One of the basic rules of trading is called the Rule of Affordability. That means; you must never take on positions that could create losses that you cannot afford. Of course, stop losses are one side of the story but a series of stop losses can deplete your capital quite rapidly. When you overtrade on your account there are a few obvious implications. Firstly, your cost goes due to more number of transactions. Secondly, too much of churning leads to bad trading decisions! Lastly, when you trade positions more than you can afford, you are likely to get overexposed to a particular sector or theme. Let us look at some basic trading rules that traders must follow and how to avoid trading mistakes. Let us also look at how to avoid overtrading and maintain a discipline driven approach to trading in stocks. Here are 7 reasons why you must never trade positions that you cannot afford.
7 reasons you must never trade positions that you cannot afford
Every trader essentially trades with finite capital. Bet it George Soros or John Paulson, the concept of finite capital and the need to manage risk is equally relevant to everyone. Of course, Soros and Paulson may trade volumes and asset classes that most traders in India cannot envisage. Having said that; the need to manage risks and to keep trading positions in control is equally relevant to them too! Let us see the 7 reasons why you must not overtrade your positions.
Trading in the market is essentially defined by risk and not be returns. Whether you are a day trader or a momentum trader or a short term trader, you must always have a picture of the amount of capital that you are willing to lose. When you take positions that you cannot afford, you are forsaking the basic condition of being in control of your losses at any point of time.
If you have heard the story of how Nick Leeson broke the Barings Bank with his derivatives positions, you will know that when you take positions you cannot afford, you are forced into a vicious circle. You take more positions (like selling options) to show revenues against your margins and eventually realize that in the process you have to your risk beyond the threshold level. You may actually find yourself at the point of no-return, as Nick Leeson found himself eventually.
Your margin requirement may open you to the risk of capital shortfall. When you start trading with your capital, you are always mentally prepared to put up a certain portion of that capital as margin. The idea is that you keep churning the positions so that not too much of your capital is locked up in open positions for too long. By taking positions which you cannot afford, you are going against this basic rule.
If you are taking on positions that you cannot afford, you are inadvertently taking on sectoral risk. Say for example, you have been keeping sectoral mix with a maximum sectoral exposure of 10%. Due to overreaching your capital, you end up exposing yourself to certain sectoral positions to the tune of 20-25%. That is not a very comfortable scenario when the sectoral goes into a sudden downturn or there are negative cues pertaining to the sector.
Apart from sectoral exposure, the other big risk you run by overexposing yourself is to open yourself to thematic risks. For example, if all your positions are exposed to stocks in the commodity theme or the interest sensitive theme then any negative cues can make a big dent on your trading performance; stop losses notwithstanding.
When you trade on margin, it is like borrowing. Just as loans have a borrowing cost and impose financial risk on your balance sheet, these leveraged positions also impose a financial cost on your trading balance sheet. The financial cost comes in the form of potential losses on the portfolio. This can become an overbearing cost in case of illiquid markets where even stop losses cannot really protect your losses at a point.
Finally, there is a major cost and tax angle to overtrading. When you stretch your capital goo much, you are already adding to the volume of transactions on your account. That automatically calls for higher cost in the form of brokerage and statutory costs. Frequent churning also leads to higher payouts in the form of tax. Remember, intraday trading is classified as speculative income and any speculative losses cannot be written off against any other heads of income.
When you trade positions that you cannot afford, you run the multiple risk of endangering your capital and also adding on to your risk and costs. It is a fit case to be doubly cautious!