What Is Overtrading? Know the Dangers & How to Avoid It
Whether it’s for investors or business owners, the stock market can be a dangerous place.
When you’re trading stocks, you have to be able to think on your feet and react quickly to the ever changing landscape. The aim is to establish a solid profit margin on your investments and have health cash reserves in order to cover any dips.
One of the pitfalls that many traders can easily fall into by not sticking to their financial plan is over trading.
But what exactly is overtrading? We’ll take you through a definition and the being able to spot the warning signs so you can take steps to avoid it.
Here’s What We’ll Cover:
What Is Overtrading?
Overtrading is the process of excessive buy and selling of stocks by either an individual trader or by a broker.
Otherwise known as churning, overtrading is essentially having too many open positions. It can also be when you are using a disproportionate amount of money on a single trade.
The dangers and laws surrounding overtrading changes whether you are an individual trader or if you’re a trading broker.
Overtrading as an Individual Trader Vs a Trading Broker
If you are an individual trader then there are no regulations or laws against overtrading. However, it can be very damaging for your overall portfolio if you’re trading for yourself. Or damaging for your firm if you're trading on behalf of someone else.
However, if you’re a trading broker then overtrading may hold far more serious legal consequences. This is because trading brokers are regulated bodies. Overtrading for the sake of generating commissions is a prohibited practise under securities law.
What Is the Difference Between Overtrading & Undertrading?
Undertrading is the literal opposite of overtrading. It means there is little to no trading activity even when the opportunity to trade is there.
If a trader doesn’t use their funds for an extended period of time, hold very small positions or have very strict entry conditions then they may be at risk of undertrading.
What Are the Dangers of Overtrading?
One of the main dangers of overtrading is the effect it can have on your overall cash flow. Once your capital dries up then you can quickly find yourself in serious trouble.
Overtrading can be a serious threat to a growing business. It can quickly lead to companies becoming insolvent if the increase in trade isn’t sufficiently managed.
Other dangers include reduced profit margins and a loss of supplier support.
To counter the capital lost by overtrading, businesses may be forced to cut prices to encourage sales and improve their turnover. This quickly eats into profit margins in an attempt to stay afloat.
Suppliers may also be hesitant to continuously offer credit if a business starts to fall behind with payments.
How to Avoid Overtrading
There are a number of measures you can put in place to ensure you avoid the risk of overtrading. These include:
Avoiding Emotional Trading: Any successful trader will tell you to trade with your head, not your heart. It’s therefore important to be able to distinguish between rational and emotional trading decisions. Every trade should be backed up with clear analysis and data.
Diversifying Your Portfolio: A rich and healthy portfolio should be spread out across many positions. This helps to minimise risks as if you see a big loss in one section, your losses can be covered in another, better performing section.
Only Trade With What You Have: The bottom line is that trading is risky. That means that you should never risk more than you can afford to lose. You should only be trading with money that isn’t vital to the running of your business. This is the best way to avoid disastrous losses.
Trading can be a fantastic way to grow and secure capital for your growing business.
However, these benefits come at a premium level of risk. The higher your investment, the more you stand to lose.
That’s why it’s important to be able to recognise the telltale signs of overtrading. This way, you can take steps to ensure you don’t fall into the trap of betting more than you can afford to lose.
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