What exactly is overtrading? How do you avoid it?

by MD Tanjib Forex Trading Author

What Is the Definition of Overtrading?

Overtrading is conducting more business than a company's operating capital can support. When this occurs, a corporation frequently runs out of cash, putting it at risk of bankruptcy. As an example of overtrading, a corporation looking to increase sales provides its customers easy credit with long payment terms.

As a result, the company must pay for the goods it sells to customers but will only get sales revenues for a short time, leaving it with insufficient cash to pay its suppliers. Overtrading can be avoided by keeping a line of credit with a lender and constantly updating a cash projection.

KEY LESSONS

When brokers trade excessively for their customers' accounts in order to collect commission fees, this is considered overtrading.

Individual professional traders may also overtrade; however, the SEC does not regulate this type of conduct.

Individuals can significantly reduce their risk of overtrading by implementing best practices such as self-awareness and risk management.

Overtrading Behaviors of Investors

Self-regulation is the only way to limit overtrading on one's own account. The following are some common types of overtrading that investors may engage in, and becoming more conscious of each can lead to greater self-awareness.

Discretionary Overtrading:

The discretionary trader employs variable position sizes and leverage and does not impose size-changing restrictions. Although such flexibility can have advantages, it is more often than not the trader's undoing.

Overtrading technical:

Traders new to technical indicators frequently utilize them to justify making a specific trade. They've already decided on a stance and are looking for indicators that back up their decision, making them feel more at ease. They then create rules, research additional indicators, and design a system. This is known as confirmation bias, and it frequently results in systemic losses over time.

Overtrading with a Shotgun:

Craving movement, traders frequently adopt a "shotgun blast" strategy, purchasing anything and everything they think might be good. Multiple small positions open concurrently, none of which the trader has a defined plan for, is a telltale symptom of shotgun overtrading.

However, a more definitive diagnosis can be reached by analyzing trade history and asking why a specific trade was undertaken. A shotgun dealer will need help providing a specific answer to that query.

The most common reasons for overtrading

While overtrading can be induced by a variety of causes, the following are some common triggers:

Making a large capital investment before generating revenue.

Customers or clients who need to pay their payments on time. Late payments jeopardize the existence of nearly one in every ten small UK enterprises.

Expenses that are unanticipated

A spike in demand or seasonal business patterns.

A significant rise in stock.

Experiencing high costs on a long-term contract before the customer pays you.

Underestimating the business costs.

Overtrading's Consequences

Overtrading can have a lot of consequences for your finances as well as the health of your business. One of the most serious consequences of overtrading is that it can cause extreme stress if you try to fulfill orders without the appropriate resources. This stress is frequently passed on to your workers, resulting in a tough working environment.

There's also the risk that the ripple effect will eventually reach your customers. You risk losing customers if you accept business that you are unable to complete either completely or to the required standard. In more serious circumstances, you may face legal action for breach of contract or non-fulfillment. This might harm your industry reputation and make it difficult for your business to recover from losses.

How to Avoid Overtrading

You may avoid overtrading by constantly managing your cash flow. Consider leasing instead than purchasing equipment. Reduce your stock levels to lower your working capital requirements. Reduce the risk of late payments from your customers by negotiating better payment terms with your suppliers. Here's more information on each of these metrics.

1. Be careful with your cash.

Consider using accounting software or hiring an accountant to assist you in better managing and forecasting your cash flow. Clear monthly statistics on your cash reserves will allow you to identify and plan around any deficits or seasonal tendencies that could lead to overtrading.

2. Instead of purchasing equipment, lease it.

Leasing equipment rather than purchasing it can be an excellent option to avoid making large upfront payments. Instead, you can spread the expenditures out over several months, giving you extra cash to handle your other monthly payments. Leasing can sometimes less expensive than buying.

3. Reduce your stock levels

"Excessive stock raises the working capital required by your business," adds Goodacre.

"It is worthwhile to invest in a modern Electronic Point of Sale (EPOS) system to assist with stock management." An EPOS system automatically tracks all of your transactions in one spot, from products brought in to goods sold out, allowing you to actively monitor and reduce stock levels based on demand.

4. Examine your business concept

Reduce the risk of late invoice payments by rethinking your business model. For example, you may accept more payments upfront or consider switching to a subscription model to receive payments more frequently.

Regular invoice automation will also help to guarantee that they are sent on a schedule, increasing your chances of getting paid sooner rather than later.

5. Bargain with suppliers

If your supplier payment terms need to be fixed, consider negotiating longer payment periods or increasing payment frequency to help you better manage and forecast your cash flow.

"Ambition is desirable and should be fostered," Goodacre argues. However, expansion must be carefully planned for, and it is critical to be aware of the possibility of overtrading so that you can take preventative measures. That way, when opportunities for growth arise, you will be better prepared to seize them.

With the American Express Business® Gold Card1, you have access to a 24-hour online Business Account management system, which allows you to keep track of your balance, credit, and purchases in real time, giving you a better picture of your incomings and outgoings. This will give you the information you need to forecast your cash reserves monthly, ensuring you always have enough finances to meet your payments and prioritize your expenses.