How to Stop Overtrading

We’ve all done it. Some days the market just seems to have our number and we end up taking too many losing trades. Or we have a good day and take one too many trades that ends up taking away much of our hard earned profit, or worse, puts us in a losing position. Overtrading is a big problem among traders. Overtrading can damage your account more quickly than almost anything else you can do. Part of the problem with overtrading is we don’t really know when we’re doing it – until it’s too late.

So what is a trader to do? How can you stay away from the evils of overtrading?

Simply put, people overtrade because they don’t have a proper trading plan. A proper trading plan is more than just preplanning your entries and exits. A proper trading plan also tells you when you’ve traded enough and it’s time to stop. With a trading plan it is virtually impossible to overtrade.

Developing a proper trading plan is not difficult to do; however most people don’t know where to start.
In order for a trading plan to be effective it must have three things:

1. A trade quota
2. A positive result
3. An escape plan

1. A Trade Quota

How do you avoid overtrading and make more money at the same time? Simple, put a limit on the number of trades you are going to take! On the surface this seems counterproductive. People think that in order to make a lot of money trading you need to take a lot of trades (hence the problem of overtrading) but nothing could be further from the truth. You don’t need a lot of trades to make money but you do need quality trades and enough “size” to trade them efficiently.

What if I told you that you could make $500,000 a year trading the emini S&P just two times a day for just one point ($50) per trade? How? By trading 25 contracts each time, that’s how. Now I can already hear you saying “But I can’t afford to trade 25 contracts!” Okay, that’s fair, but what if you traded 5? That would still be $100,000/year. What if you traded 3? That’s $60,000/year. Regardless of how many contracts you are able to trade, the point is that you are making incredible returns on only 2 trades a day!

Did a light just go on? Did the previous example show you that it is not the frequency of trading that makes the money; rather it is taking quality signals combined with the largest position size you can afford that makes those profits possible? So if you’ve been overtrading because you think you need to trade a lot in order to make a lot of money, I hope you can see that is a myth. Your goal as a trader should not be about maximizing the quantity of signals; rather it should be about maximizing the quantity of your position.

How many signals are enough? For most traders two to four signals a day will give them enough opportunities to maximize their earnings without risking damage to their account. While this does not seem like a lot of trades remember that the more trades you take the more you bring the Law of Averages into play and the more likely you are to incur a loss. There are many days that I can go 4 for 4 trades and post a $1000+ profit.

2. A Positive Result

It’s funny, but while all traders trade to make money they rarely consider finishing the day “in the black” as an important part of their trading plan. Yet this is precisely what you need to do if you are going to be a successful trader! By having a plan to finish the day with a positive result, you not only prevent overtrading but improve the odds of finishing the day with a profit as well.

How does this work? Let’s say you have a daily trading objective of 3 trades and finishing with a positive result. Let’s say your first two trades made $100 profit per contract each. You currently have a profit of $200 per contract, but your plan is to take 3 trades, so you’re still on the lookout for another signal. Now let’s say that your third trade doesn’t work out and gives you a $300 loss. You are now net -$100.

You’ve taken three trades as per your plan; however you don’t have a positive result yet, so you keep looking for another trade. The fourth trade yields a $100 profit so now you are back at breakeven; however your trading plan says you need to have a positive result, so you look for another trade. Your fifth trade also works out and gives you $100 profit per contract. Now your day is done because you’ve hit your 3 trade/day limit AND you’ve finished with a positive result.

Now that might not seem like a lot of money, but remember just like the emini example earlier, these results are per contract. If you were trading three contracts each time then you finished the day +$300, five contracts, +$500 and so on. As you can see it doesn’t take long for results like these to add up to a point where you could trade even larger positions thereby further increasing your earnings and all without the danger of overtrading your account!

3. An Escape Plan

As with all things trading related, nothing works 100% of the time. There will be days when the market just seems to “have your number” and you can’t find a winning trade to save your life. On days like this you need an escape plan to protect your account.

An escape plan can take several forms but it is important that you have one. The simplest escape plan is to set a loss limit, or maximum drawdown for the day and is the easiest way to keep from “blowing up” your account. A maximum loss can either be a “pain threshold” dollar amount or a percentage of your account. A 5% account drawdown is enough risk to give the market a fair chance but not so large that you can not recover from the loss in a day (or two) if the market goes against you.

Another form of escape plan is to stop trading if the market is acting too unpredictably. This is easier to determine if you are using a trading system to generate your signals or if you have a strict method of entering your trades. In this instance you would stop trading if the system gives you “X” false signals.

For example, I use the DTS trading system to generate my trade signals. I know the system produces high quality signals, so if I get a losing trade off a quality signal I know that something is not right with the markets. Therefore I have a “three good signal loser” limit: if I get three losing trades off good signals, then I know that the markets are not behaving as they should and I stop trading the rest of the session.

The key to consistent profits is not as elusive as most traders think. Most traders fail to make money because they overtrade. Almost everyone is profitable at one time or another. The difference between the traders who make money and the ones that don’t is the traders who make money know when it’s time to quit.

Eliminating overtrading is all about having a plan to keep your emotions in check. The markets will always be unpredictable, but by knowing in advance how you are going to deal with the markets puts you one step ahead of the majority of traders who continue to on trade their emotions and jeopardize their accounts in the process.

For more from Erich, visit the Indicator Warehouse for additional futures resources and NinjaTrader Indicators.