Sunday, August 10, 2008

How Do I Avoid Overtrading?

A trader recently posed this question in a comment to a blog post: How can I avoid overtrading?

First, let's get definitions straight:

Overtrading typically has two connotations: trading size that is too large for one's portfolio (i.e., taking too much risk per trade) and trading too often (i.e., when an objective edge for the trade is not present).

Keeping metrics on your trading will tell you if your size is too large (you will have large P/L swings and drawdowns and large outlier gains and losses) and/or if you're trading too much (you will have more losing trades than winners and will tend to lose more on days in which you're trading more).

The antidote to overtrading--in both its forms--is rule-governance. Trading rules are what guide our position sizing and risk-taking, and they are what put us into markets and keep us out.

Many times, traders do not formulate their rules explicitly: they do not have clear and concrete formulas for position sizing, and they do not have hard-and-fast rules for when to enter and exit. It is a curious, but surprisingly common error to assume that discretionary trading means trading without rules. Discretion means that we employ real-time judgment in entering, exiting, and managing positions. Rules can guide that discretion, just as rules and plans may guide a quarterback who calls plays in a huddle and changes those calls at the line of scrimmage.

We avoid overtrading in position-sizing by limiting the losses on any single trade to a small, fixed fraction of portfolio value. We avoid overtrading in the number of positions we enter by limiting trades to those setups (entry criteria) that have demonstrated their profitability. For example, I will not take a short position in a market in which the cumulative NYSE TICK is making new highs; I won't trade at all if volume falls below threshold levels. These rules and guidelines keep us out of unprofitable situations, and they help us concentrate our capital in areas of greatest opportunity.

It is through repetition that rules turn into habits. This is a topic I'll be taking up in the new book. To avoid overtrading, you lay out your trading rules and then you rehearse and follow those rules so consistently that they become automatic. You can't expect to follow a discipline that you haven't clearly defined in the first place.


Understanding Lapses in Trader Discipline

Why Traders Lose Discipline