Knowing when to stay out of the market, and when to take risk “off the table” is a key skill that needs to be learned.
Brokers make big bucks from frequent “volume” traders. After all, trade volume is how they make their profits. But over trading is not just bad because it’s lining your broker’s pocket with your money.
There’s also strong evidence that shows traders who’re “over active” in financial markets have significantly worse returns than those who aren’t.
Having insight into the behavioral problems of over trading can give you a big advantage over your lesser informed competitors. Read on to find out more.
What It Means to “Over trade” the Market
Trading strategy plays a key role in knowing when and if to trade in a given situation. Clearly, some forex strategies, like “grid trading”, “doubling up/down” or “scalping” can generate large volumes of trades.
However with a properly executed strategy, the trading rules should be underpinned by a suitable money management plan. Overall, this “trading system” should say when you trade and when to sit on the sidelines. (Forexop’s money management section covers this topic in more depth – see here).
The best definition of over trading is that it means frequently departing from a trading plan – or having no plan at all. In other words it means opening high numbers of “unplanned or poorly planned” trades. Stubbornly holding failing trades also falls under this category.
Beware of “over confidence” • One common hazard the new trader faces is over confidence. Research shows over confident traders open more trades and hold on to more positions than their more rational counterparts.
If it isn’t nipped early, over confident trading can turn into outright gambling. This is when systematic trading turns into optimistic speculation. This type of trader “juggles” a large number of losing positions believing at some point some or all of them will become profitable.
Understanding this psychology and suppressing these behaviors is something many professional traders try to do. For example the “disposition effect”, as it is called, is something many traders and investors are guilty of and that professional try to avoid. This is the tendency to hold on to losing positions for too long while cashing winners too quickly.
Studies of real traders has shown that overanalyzing positions and performance actually encouraged bad practices like over trading.
In the past, it was a common assumption that all actors in the financial markets apply cool, calm rational decision making – leading to so called perfectly efficient markets. Yet studies in behavioral finance are showing this is far from the case. Market players simply don’t act this rationally, at least not all of the time.
One reason psychologists tell us is that innate behavioral patterns will often trump rational decision making. Even when we’re aware of what’s going on and bringing this knowledge to bear it is difficult if not impossible to control these motivations because they are so instinctive.
For example people have an extremely strong compulsion not to realize losses. Even if this harms their overall objective of making profits.
We have a bias towards holding on to losing positions and closing out profitable ones too early. The opposite of what traders should be doing.
One of the reasons behind this is loss aversion. Research shows most people strongly prefer avoiding losses to acquiring gains. In other words, the pain of a financial loss far outweighs the thrill of a gain, even if that loss is far smaller than the gain.
Traders who fall into this trap often wind up with an excess of toxic positions in their trading book which they’re reluctant to let go of. Even when these positions are incompatible with their logical view on the market.
Money flows and events in other financial areas play a profound role in both volatility and spot forex rates.
It’s not just amateur traders that do this either. Professionals can be just as prone. Several studies have been carried out analyzing both institutional clients and discretionary traders’ positions. These show consistently that losing positions were on average held longer than winners.
Over trading can have several negative consequences:
- Information disadvantage: Over active traders don’t have enough time to weigh up the possible outcomes of a trading opportunity and so make a reliable informed decision.
- Increased trading costs due to unnecessary and unprofitable turnover
- Additional time and resources needed to maintain and supervise the trading book
- Trader fatigue and higher chance of making mistakes
- Higher margin requirements
- Unnecessary and sometimes extreme risk exposure
- Not being able to have a “clean book” – Highly desirable during high risk periods or important news announcements
- The “opportunity cost” of missing genuinely profitable trading situations when they arise
Of all the above, perhaps the last one is the most important. The opportunity cost means that when your capital is tied up, you may not have the full capacity to trade when a real opportunity arises. This means highly profitable trades can be missed.
Maintaining a Consistent Market View
Due to the interrelationships of the FX markets, maintaining a consistent view is essential. Those who over trade often hold positions that are fundamentally at odds with one another. For example, an over trader may be bullish on the U.S dollar at one instant, yet still have historical short trades from months earlier. Or he’ll be both long and short on multiple currency pairs which move in the same direction (have positive correlation).
If this isn’t part of a planned strategy, it usually comes down to loss aversion tactics. Taking the time to both research and analyze information – and consolidate this into a unified view – is a vital skill traders need to develop.
Overcome the Information Advantage
One area institutional players have a major advantage over independent traders is in access to information. They have an abundance of information all around them
Information from strategists, research teams, trading peers, the sales desk, important clients as well as the trading desk managers. In most financial institutions this all comes together to form a company wide “market analysis” on all fronts.
Professional traders will be challenged and may have to justify their reasons for holding a position. As well as trades that are not consistent with a current market outlook. Traders working independently don’t have this peer scrutiny. This makes self-motivation and awareness a key aspect of success for the independent.
Moreover, good risk controls should prevent proprietary trading from extending into dangerous speculation – though of course this doesn’t always work.
Independent traders don’t usually have these checks and balances or information at hand. However many good resources are still available if you’re prepared to do the leg work to find them. Most investment banks publish summaries of their daily financial outlooks. These are created for their private and corporate clients, but they’re often available online for anyone to download.
Having a consistent market view, both on fundamental and technical level should be the driving force underlying your trading strategy.
Practical Tips to Avoid Over Trading
- Stick to a plan. Having a trading plan isn’t a mantra for success. But it is much easier to diagnose and correct when things go wrong. This isn’t possible when opening and closing trades on a whim.
- If you can’t avoid the compulsion to trade consider having two accounts. Have one primary account where you follow good practice. Use a secondary, risk account for more speculative trading activity. It’s easier to compartmentalize and deal with risk this way.
- Follow a conservative money management procedure. Doing this will ensure you cut your losses quickly and don’t go overboard on risk.
- Have your own “market outlook”. Maintain this as a daily journal and keep it updated. Make sure your trading plan and holdings are consistent with your outlook. Holding losing positions in the hope things will turn at some point is rarely a good idea.
- Plan your trading week in advance. Take note of the economic calendar ahead and determine how any releases may impact your positions. Planning ahead will help you to avoid panicked trading decisions.