- 2001: Volume 10, No. 2 Over-Trading

Over-trading is an affliction difficult to self-diagnose and a very enjoyable way to go into Chapter 11. We recognize it easily in others, but not in ourselves so it is useful to understand some of its causes.

Over-trading has a particular financial meaning related to the number of open positions and available capital. We are not interested in these relationships. For us over-trading is a psychological problem that consumes profits and destroys trading capital. It stands in the doorway to the casino and all of us have felt the lure of a galaxy of market “slot” machines. With so many opportunities it becomes frustrating to stay in a non performing trade while other stocks zoom past.

For many traders, the two main roots of over-trading lie in a need to chase the market to recover losses, and in a desire to look busy. The first leads down a road to gambling. The second, our instinct to look busy, usually costs us a great deal.

Often we find it difficult to develop the patience to wait for good trades. We feel we should be doing something. Our partner encourages this feeling, stating openly that they cannot understand how we are making money by drinking coffee and reading fiction books while waiting for our buy and sell criteria to materialize.

This criticism gets to the very core of our belief about the relationship between reward and work. We tolerated long hours, high levels of stress and frenetic office environments because they delivered high pay, relaxing holidays and an up-market lifestyle.

Private trading offers the opportunity to have all of benefits above without the downside of a busy office. This breaks the relationship between work and reward and many of us feel very uncomfortable. People with intensive work ethics have to stare at the screen all day to reassure themselves that they have worked hard.

There is a danger here. If we are not careful we create more work, extending our activities by taking on new market segments or derivative markets such as options and warrants. We increase the workload by taking many new positions financed by trading profits. Stress builds when we use additional capital borrowed from other sources, or by margin borrowing. No matter which combination we choose the effect is the same. We create more trading activity to satisfy our work ethic.

This is one of the causes of over-trading and it is easy to recognize in our friends and colleagues. But how do we recognize this affliction in ourselves?

Over-trading is about motivation, and it starts when positions are opened primarily because the trader feels the need to do something other than wait patiently for the best opportunities to arise. This temptation is always present because somewhere in the market good money is made every day. We suspect if we were more fully exposed, more fully committed, then we too could take part in the great accumulation of wealth.

Putting a hard number on over-trading is difficult. The day trader takes on more positions than an investor. A position trader completes less trades than an active commodities trader. In assessing the tendency for real trading or over-trading the primary test is money management so we look for a “Yes” answer to each of these four questions:

• Is each trade clearly based on sound financial analysis?
• Is each trade part of an over-all money management objective based on matching position size with risk?
• Does each trade have clear financial objectives which determine the exit conditions?
• Does each trade only use capital allocated from previous trades?

Ask these questions of each new trade. If the answers are all affirmative then the trade is well considered and part of a strategic market approach. If two or more questions are honestly answered "No" then the danger of over-trading is real. A "No" answer suggests trading decisions are emotionally driven and this often draws on a need to justify the rewards.

Most people do not relate money management and over trading. Those who over trade do not answer these questions honestly. Their answers are designed to deceive themselves and others. Below are four typical answers about how trades are identified. Hear them and they all suggest over-trading.

• The proposed trade is quickly assessed on the basis of gross returns, or the current low with the highest high over the last year.
• Position size is determined by how much cash is currently available for trading.
• Exit is loosely based on previous highs or gut feelings. Some positions are closed early to free up cash for new, more attractive positions.
• Money from other sources, such as your day job, is constantly added so new position sizes can be increased.

Catch yourself doing any of these and you have taken a step towards over-trading. Sometimes this is also a step towards using the market to gamble, and in Market Trading Tactics we do look more closely at how you can tell the difference.

Over-trading is avoided when we accept that significant rewards do flow from work that does not involve long hours, stress or sweat. We must appropriately value our intellectual and analytical contribution to the process of trading and accept our rewards as commensurate with this. We must understand no additional work is required to justify our income. Do this and we can use our increased leisure time wisely for some activity other than trading.

Daryl Guppy is a full time trader and author of Market Trading Tactics and Share Trading. He holds trading workshops in Asia and Australia. He can be contacted via www.guppytraders.com.