What is over-trading?
Over-trading refers to the excessive buying and selling of stocks by an individual broker or dealer. The two are entirely different situations and have very different implications. An individual trader, whether working for himself or being employed on a trading desk by a financial firm, will have rules about the level of risk he can take, including the number of trades that suit him. Once they reach this limit, to continue to trade is to do it in an awkward way. While such behavior may be bad for the merchant or bad for the business, it is in no way regulated by outside entities.
However, a broker upgrades when he excessively buys and sells stocks on behalf of the investor simply with the result of increased commissions. Over-trading, also called churning, is a practice prohibited by securities law. Investors may find that their broker has traded when the frequency of their transactions becomes counterproductive for their investment objectives, resulting in ever higher commission costs with no observable results over time.
Key points to remember
- Over-trading is prohibited for brokers who advise investors and is regulated by the SEC.
- Brokers may have subtle incentives to trade and investors should beware of these practices.
- Individual professional traders also over-trade, but this activity is not regulated by the SEC.
- Individuals can significantly reduce the risk of being overwhelmed by following best practices such as self-awareness and risk management.
Understanding the overshoot
Overtaking can happen for a number of reasons, but all of these reasons have the same result: poor investment performance at the expense of increased brokerage fees. One of the reasons why this practice is known occurs when brokers are forced to place newly issued securities subscribed by the investment banking branch of a company. For example, each broker can receive a 10% bonus if he can guarantee a certain allocation of a new title to his clients. These incentives may not have the best interests of investors in mind. Investors can protect themselves from over-trading (churning) via a global account – a type of account managed for a flat rate rather than charging a commission on each transaction. The SEC also investigates complaints from brokers who tend to put their own interests before their customers.
Individual traders generally over trade after suffering a large loss or a number of smaller losses in a generally long loss sequence. To recover their capital or to “take revenge” on the market after a series of losing trades, they can strive to make profits wherever they can, usually by increasing the size and frequency of their transactions. Although this practice often results in poor trader performance, the SEC does not regulate this type of behavior as it is done for its own account.
The Securities and Exchange Commission (SEC) defines overshooting (churning) as an excessive buying and selling in a client’s account that the broker controls to generate increased commissions. Brokers who trade excessively may break the SEC Rule 15c1-7 which governs manipulative and deceptive conduct. The Financial Industry Regulatory Authority (FINRA) governs trading under rule 2111 and the New York Stock Exchange (NYSE) prohibits trading under rule 408 (c). Investors who believe they are victims of churning can file a complaint with the SEC or FINRA. (For more information, see: How to tell if a broker is canceling your account.)
Types of overshoot among investors
Overtaking on one’s own account can only be limited by self-regulation. Below are some common forms of over-trading that investors can engage in, and starting to learn about each can lead to better self-awareness.
The discretionary trader uses flexible position sizes and leverage and does not set rules for size changes. While such flexibility may have its advantages, more often than not, it turns out to be the trader’s downfall.
Traders who are new to technical indicators often use them as justification to make a predetermined transaction. They have already decided on the position to adopt, then look for indicators that will support their decision, making them feel more comfortable. They then develop rules, learn more indicators and design a system. This behavior is classified as confirmation bias and generally leads to systemic losses over time.
Eager for action, traders often develop a “shotgun blast” approach, buying everything and everything they think is good. A telltale sign of shotgun trading is that several small positions are open simultaneously, none for which the trader has a specific plan. But an even firmer diagnosis can be made by examining the history of the trade and then asking why a particular trade was done at the time. A shotgun trader will find it difficult to provide a specific answer to this question.
Traders can take a few steps to prevent excessive trading:
- Show self-awareness: Investors who are aware that they can over-trade can take steps to prevent this from happening. Frequent assessments of trading activity can reveal patterns that suggest that an investor can trade. For example, a gradual increase in the number of transactions each month may be a sign of the problem.
- Take a break: Over-trading can be caused by the feeling that investors have to trade. This often results in less than optimal transactions that result in loss. Taking time off allows investors to reassess their trading strategies and make sure they match their overall investment goals.
- Create rules: Adding rules to enter a trade can prevent investors from placing orders that deviate from their trading plan. Rules can be created using technical or fundamental analysis, or a combination of both. For example, an investor can introduce a rule that only allows him to trade if the 50-day moving average has recently exceeded the 200-day moving average and the stock pays a return greater than 3%.
- Be involved in risk management: traders who exercise strict management of the size of positions tend to outperform those who do not, regardless of the systems or deadlines negotiated. Risk management on individual trade will also spread the probability of a sharp decline, in turn reducing the psychological traps that arise from such circumstances.