Getting started in the financial markets can be exciting: all the new terminology, the charting tools, the prospect of financial gain. Swept up in this current, many novice and even some experienced traders fall into a well-documented trap: overtrading.
Overtrading is the act of placing unnecessary or imperfect trades, simply because you can. For traders who don’t use demo accounts, it is particularly dangerous, as they have no means to try out new strategies without putting their capital at risk. It often takes a while to become fully accustomed to a particular trading style, and particularly if you aren’t careful with leverage this can be an expensive learning curve.
Learning new things and trying them out is an important part of your development, but doing so in a haphazard or chaotic manner can destroy your returns. In this article we will look more deeply into the causes and effects of overtrading, and what you can do to protect yourself.
How it happens
Much of the work of managing trading psychology involves dealing with the fear of losses and other negative emotions. Overtrading by contrast is often a result of an excessively positive sentiment, or a desire to test out new theories. Whilst being enthusiastic is very important, knowing how and when to keep it under control can save you problems later on.
One of the most common causes of overtrading is partially digested information. A trader who has recently discovered the world of candlestick chart patterns may be prone to seeing Doji stars or head and shoulders patterns everywhere he looks; when a certain chart doesn’t show the desired pattern, he squints, zooms in on another time period and looks and looks again until he does.
The problem with this is it is very easy to start seeing things that aren’t really there: with a hammer, everything starts to look like a nail. Particularly for subjective technical strategies such as Fibonacci retracements, where experience plays a major role in the exact placement of the levels, this can soon become a real problem.
Rushing into new trading strategies is a difficult habit to break, as it’s often quite helpful to match your reading with your trading activity, and to try and put into practice new ideas as soon as possible. Problems arise in two situations: when you start entering too many trades at once, limiting your returns and reducing the due diligence that goes into each individual position, and with the phantom patterns situation described above.
Dangers of overtrading
Retail forex margins are not as high as for many other asset classes, and they are considerably lower than they used to be. Even so, many small volume traders have their returns eaten into quite significantly by overtrading.
A lot of this is just down to position size discipline – do not assign 0.1% of your cash to 1000 different trades (unless there are ten million AUD in the portfolio…). But away from obvious mistakes, even experienced traders can be caught out when they see multiple simultaneous opportunities and try to follow too many at once.
A small trade is often proportionally more expensive. Therefore, it is usually better to concentrate your portfolio on a few high-conviction, well managed trades then spread your money too thinly. Balancing this with the need for diversification and risk management can be a challenge, but in general if you find yourself wanting to place a trade ‘to see what happens’ or check if a new strategy works, it might be better in your demo account.
When does experimentation become overtrading?
One of the challenges of mastering your trading psychology is being able to identify when your thought process could be leading you astray. This is particularly difficult in the case of overtrading. Whereas it is normally obvious to us when we are feeling afraid, a desire to trade can often seem like a wholly positive emotion that we don’t need to control or limit.
Balancing a healthy interest in testing out your strategies in live markets and the temptation to overtrade is a complicated task. Be sure to constantly review your trades and trade performance to ensure they are in line with your preformed strategies.
If you are experimenting with a new trading strategy, assign a specific percentage of your portfolio that you want to use for this purpose. Under no circumstances should you use the remainder of your portfolio to do this – always before placing any trades check your current level of investment and see how it matches up to your ideal portfolio.
How to protect yourself
Overtrading, like many other psychological traps for traders, is stubbornly resistant to most risk management techniques. Even if your stop losses and position sizes are perfect, if you consistently overtrade you will lose money. There are several strategies you can use to prevent this.
The first, and best corrective is to use a forex demo account. When trying out a new strategy, one you haven’t yet fully mastered but understand and are interested in using, always begin by placing paper trades with your demo account. This will allow you to work through the initial phase of over-excitement without damaging your portfolio returns.
If you are happy with a trade’s demo performance, and keen to start using the same technique for real, begin with a smaller position size than you would use for a more familiar trade, and use a tight stop loss to prevent the trade going against you. Consider reducing or exiting previous trades to allow ‘space’ for your new strategy to develop.
Signs you may be overtrading
There are a couple of tell-tale signs to watch out for when thinking about placing a new deal:
- Does this trade fit in with your overall position sizing strategy? If not, it may be worth reconsidering.
- Are you testing out a new technique for the first time? If so, be extra careful in choosing your entry and exit points. Consider using your forex demo account instead.
- In the case of a pattern formation or trend reversal, would waiting slightly longer confirm whether it is indeed ‘real’? If so, the slightly reduced profits are probably worth accepting.
All of these checks can help protect you from the potential costs of overtrading, saving you money, and freeing up your portfolio for more suitable trades.
An example
Let’s say a skilled fundamental trader has recently started reading more into momentum based technical strategies. He aims to keep 90% of his portfolio invested, which he already is with his open fundamental trades, but on reviewing the USD/JPY chart he finds an excellent opportunity for a long momentum trade.
An inexperienced or excitable trader may happily rush off and use the remaining 10% of his portfolio on the trade. This can happen almost without realising – if you are fully invested, you will need to decrease other positions or wait until they close before adding a new one. Particularly with fast moving technical trading this can be a real frustration as the opportunity may soon disappear.
No matter how strong the temptation, you must always remember to stick first and foremost to trade size and portfolio allocation discipline. No trade is so excellent that you can’t afford to miss out and wait for it to arrive again.
As always, the best protection against this error is the prudent use of a forex demo account for all new strategies. Demo accounts are not something just for novices, but a vital tool for all traders, and that unlike backtesting allows you to test trade ideas in live market conditions.
How Rakuten can help
The best cure for overtrading is to be able to test out your technical and fundamental strategies in a risk-free environment, until you can be sure they work and that you’ve understood all their intricacies. With that in mind – and if you don’t already have one – why not open a free demo account today?