Definition and Examples of Overtrading
Overtrading involves buying and selling investments too frequently. Not everyone will agree on the line between normal trading and overtrading. A financial advisor, for example, may have their own recommendations regarding what qualifies as overtrading based on a trader’s particular circumstances. Overtrading is also a strategy used by some brokers to try and collect more commissions. This is known as churning and is illegal.
Alternate name: Excessive trading, churning
Overtrading is a subjective term; excessive can mean different things to different people. Understanding what overtrading is can help you stay within your brokers’ rules, if applicable, and it can also help you avoid trading so much that your returns suffer. In some cases, brokerages or mutual funds can have their own rules about overtrading. Overtrading can vary from one trader to the next, but generally, it involves making too many trades to the point where doing so goes against the trader’s best interests. Here’s a situation you might find yourself in that could be considered overtrading: Suppose you bought one share of a stock valued at $100. The next day, the price drops to $95, so you sell it. The following day the price goes up to $105, so you buy it again. The price falls the next day to $102, and you sell it again. In this case, overtrading would have caused you to lose money both times you bought and sold the stock. Instead, if you only bought once at $100 and sold once at $102, you could have made a profit.
How Does Overtrading Work?
One way to look at overtrading is to compare it to the concept of overthinking. Thinking is generally good, while overthinking is generally bad. There is nothing wrong with trading a high number of stocks—but when your trading gets to the point of creating losses or going against your broker’s rules, it falls into the dangerous area of overtrading. Whether your trading volume is too high or not can depend on your financial circumstances and other factors such as brokerage fees, taxes, or trading laws.
Trading Volume and Fees
An institutional investor such as a hedge fund or a professional day trader might buy and sell stocks far more frequently than you do. For them, that might be considered ordinary trading, not overtrading. They may be better able to absorb transaction fees or commissions than someone who has fewer assets, less financial backing, or broker agreements like monthly fees rather than per transaction fees. If your brokerage charges transaction fees, they can cut into your returns the more you trade. A $5-per-trade commission might not seem like much, but it is. For instance, say you buy and sell the same stock 10 times. You’re charged per trade, so you’d end up making 20 trades at $5 each. Your broker’s commission would be $100 that day. If you had used $1,000 to make those 20 trades and made a 10% profit ($100), you’d have overtraded because you didn’t get to keep any of your profits; they would have only gone toward your broker’s commission. If you invest in or trade mutual funds, you might have to pay fees, too. These fees would be separate from your broker fees and can further increase the cost of excessive trading.
Taxes
Investors and traders pay taxes on the capital gains they make from trading because the gains are taxable. The IRS defines investors and traders by their activities, how long they hold their assets, and how they earn money from them. Additionally, tax laws treat investors and traders differently—the laws are complex, and taxes can increase the costs of overtrading.
Trading Rules and Laws
Some financial organizations or financial instruments also have rules around excessive trading. For example, a mutual fund company may want you to limit the number of times you buy and sell the fund in a short period to keep from causing instability in the fund. A pattern day trader is defined by the Financial Industry Regulatory Authority (FINRA) as someone who makes more than four trades within five days. Brokers are required to impose margin account requirements on traders who meet this criterion. If your brokerage labels you as a pattern day trader due to overtrading, you’ll have to maintain a minimum margin account balance of $25,000 in cash or securities. If you have to put that much aside, you might not have much left to trade.
What Overtrading Means for Individual Traders
Generally speaking, traders and investors tend to be bad at timing the market or predicting when prices will rise or fall. So you may be better off taking a long-term trading view: Buy an asset and let the price rise enough so that the smaller price fluctuations won’t cause a loss when you sell. You’ll have fewer fees to pay, and if you wait long enough (one year or more), you may be able to pay the lower capital gains taxes instead of counting your gains as income and being taxed at a higher rate. Having patience when you trade might make you more money than overthinking and overtrading. Plus, depending on your brokerage, you may rack up fees for every trade, so overtrading can get expensive. Take a look at any rules that might be in place with your brokerage or in specific investments so you aren’t subject to overtrading. Speaking with a financial professional may also help you get a sense of where your line between trading and overtrading is. For some traders and investors, day trading may align with their trading goals. But for many others, trading too much hurts their results due to poor market timing, transaction fees, and other expenses.
