The Van Tharp Institute

May 11, 2005 — Issue #219

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In this Issue:

Feature Article

Wash Sale Rules and Your Basis, by Stephen S. Meredith, CPA, PLL,
Introduction by Van K. Tharp

Trading Tip

Don’t Underestimate the Risk of Having a Big Loss Hit Your Strategy, By D.R. Barton, Jr.

Listening In...

Tharp's Recommends 50k-100k to Start, But What About Forex? 

View this newsletter on-line, or read back issues

 

Feature

Wash Sale Article Introduction, by Van Tharp

I’d really encourage you to read the wash sale article below.  Many traders, brokers, and even accountants do not understand this rule.  For example, I recently signed up for a service with my broker that would automatically generate my schedule D.  That seemed significant because I had over 200 trades.   

However, when it came to wash sales all they did was exclude the losses – they didn’t update the basis.  Thus, I had a significant loss (i.e., $3,000) followed by a nominal gain ($100).   The software simply deleted the loss as wash sale and counted the gain.  

What it should have done is change the basis on the second trade and call it a $2,900.   Thus, Steve’s article could save you thousands of dollars. --Van

 

Tax Tip

Wash Sale Rules and Your Basis

by

Stephen S. Meredith, CPA, PLL

 

Most securities investors are generally aware of the Wash Sale Rules under Internal Revenue Code section §1091.  Those rules, like most of the code, are complex and have exceptions that might affect you.  If you understand them, the rules can be used effectively to help you in designing your trading system, thereby increasing your net profits.

Code section §1091(a) is summarized by the following: No LOSS can be claimed if you sell a stock and purchase the same stock (or an option to buy the same stock) within 30 days before or after the date of the sale.  Securities Dealers are exempt from this rule because they treat all their stock as inventory under other code sections.  Traders making the election under §475(f) are not the same as Dealers, and therefore the wash sale rules still apply.

How do you calculate your basis in the new stock if the wash sale rules apply?  Under §1091(d) the new basis “shall be the basis of the stock or securities so sold or disposed of, increased or decreased, as the case may be, by the difference, if any, between the price at which the property was acquired and the price at which such substantially identical stock or securities were sold or otherwise disposed of.”

The Treasury Department is supposed to issue regulations to further explain or detail the Code.  In Regulation §1.1091-2 the regulations give two very clear examples of how to compute the basis in the new stock.

Example 1 – Investor/Trader buys a share of X Corporation for $100 in June of 2004.  The stock is sold for $80 on January 15, 2005.  On February 1, 2005 she buys a share in the same company for $90.  The loss is disallowed by the wash sale rule.  The basis is now $110. (Basis of the old share of $100 plus the difference between the cost of the new share $90 over the sale of the old share $80)  This can be better understood by saying that since the loss of $20 is not allowed it is added to the cost of the new stock bought at $90.  The basis of the new share is now $110 and when it is sold later your future gain will be less because your basis has been increased.

Example 2 – Investor/Trader buys a share of X Corporation for $100 in June of 2004.  The stock is sold for $80 on January 15, 2005.  On February 1, 2005 she buys a share in the same company for $70.  The loss is disallowed by the wash sale rule.  The basis is now $90. (The basis of the old share of $100 less the difference between the cost of the new share $70 over the sale of the old share $80)  This can be better understood by saying the since the loss of $20 is not allowed it is added to the cost of the new stock bought at $70.

One other major point to remember is that the holding period for this share of stock is affected by the “tacking” principle.  That means the date of purchase of the original share, which was June 2004, is deemed to be the purchase date of the new share bought in February 2005.

How does this affect your trading system using Dr. Tharp’s strategies?  Suppose you buy a stock, using example 1 above, four times in four days.  Each day you sell at a loss at the R1 point.  Although the loss is not deductible, the stock eventually does what you think and on the fifth purchase you end up holding the stock until the price goes up to $150.  Your basis increased each time you sold at the R1 point by $10.  Your basis is now $140.  Your sale at $150 creates a gain of only $10.  This is easily checked by looking at the results as if the wash sale rule had not applied and aggregating your profits and losses.

Example 3 –

Purchase for $100, sell for $90 – loss of $10.

Purchase for $100, sell for $90 – loss of $10

Purchase for $100, sell for $90 – loss of $10

Purchase for $100, sell for $90 – loss of $10

Total loss at this point = $40

Purchase for $100, sell for $150 – ordinarily a gain of $50

Netting gains and losses together yields a $10 profit.

NOTE – because of the wash sale rules, you would only report the last sale.  Claim a sale of $150 and a cost of $140.

Example 4 – Assume a similar starting point for the facts in this example.  This time we’ll have an initial loss followed by a gain that recovers only part of the loss.  The trader then decides not to reinvest in this stock.

Purchase for $100, sell for $  80 – loss of $20

Wait three days and set up the trade again.

Purchase for $100, sell for $110 – gain of $10

Net loss of $10, which is deductible.

NOTE – because of the wash sale rules, you would only report the last sale.  Claim a sale of $110 and a cost of $120.

The basis calculation goes like this:  The loss of $20 is not deductible due to the wash sale rules.  The basis in the new stock purchase is $120.  Since the new stock was sold at $110, the $10 loss is fully deductible.  You would report a purchase price of $120 and a sale price of $110.

Does this affect Traders who use the 475(f) election?  Yes, it does, and it can get a little more complex.  At the end of each year, Electing Traders mark all their securities to market value and effectively “pretend” they sold everything.  They claim all gains and losses and establish a new basis for all their existing security positions.  In example 3 above the trader would have compared her year-end adjusted basis under the wash sale rules to the market value at year end and declared the gain or loss in the current year.  This may result in a deductible loss this year. When the stock is then sold in the following year, without a repurchase, there would be a larger gain to declare.  This demonstrates that there is a timing difference between how traders report their gains and how investors report their gains, even though over the two years the end result would be the same.

Stephen S. Meredith is a CPA in Richmond Virginia.  He specializes in preparing income tax returns for all types of businesses, individuals, estates, and trusts.  He also consults with new business owners on how to properly structure their business to get the maximum benefit from current tax laws.  Steve deals with many stock market and real estate investors.  He has clients nationwide and lectures regularly on tax topics. 

 

Editors Note: Throughout the issues you will see certain words with odd spellings, such as Fre-edom and mort-gage. This is because spam filters are likely to block message that contain certain words and this is one solution.

 

Trading Tip: 

Trading Tip

Don’t Underestimate the Risk of Having a Big Loss Hit Your Strategy

 

by  D. R. Barton, Jr.

"The average pencil is seven inches long, with just a half-inch eraser - in case you thought optimism was dead."

-- Robert Brault

I can still here the groans.  I was teaching an IITM course on money management.  We were preparing to do some simulations using trade distributions from each attendee’s personal trading or from a system they wanted to trade.

I had asked how many people had a trade that was worse than –2R (a trade that had resulted in losing more than twice what they risked). Only a couple of hands were raised in the whole room.  And almost everyone in the room had strategies that held trades overnight.

I’m sure there was a portion of the room that was just trying to please Van.  He had stated earlier in the course that most losses bigger than –2R are psychological mistakes.  And I agree with him that most are.  But there are moves in the market that happen overnight (and occasionally during trading hours) that produce big and unavoidable losses.

Such items happen much more frequently than we suspect.  Earnings reports can move stocks in a big way (either up or down) and most are announced before or after the market closes.  News items such as product problems and accounting irregularities can move prices in big way.  All of these events can cause major gaps openings against our positions.

The problem is that most people tend to ignore these violent movements, minimize their importance, or fail to realize their frequency.

In two books that I’m currently studying on behavioral finance, the authors both come to the same conclusion in different ways:  financial markets have bigger and more frequent price shocks than most models predict. The same can be said for our beliefs about our individual trading and investing strategies.  We don’t plan for the frequency or severity of price shocks that can hit us.

In the afore mentioned money management class, when I insisted that everyone add a–3R, –4R or even a –5R loss, there was much groaning in the room.  The protests began immediately.  But anticipating a severe negative price movement in your system is critical to long term survival in the trading and investing game.

I have talked to many folks who have blown up their accounts.  I don’t think I have heard one person say that he or she took small loss after small loss until the account went down to zero.  Without fail, the story of the blown up account involves inappropriately large position size or huge price moves, and sometimes a combination of the two.

The bottom line in anticipating future trading results is that you have to watch out for that big negative trade with your name on it.  This shouldn’t dampen your enthusiasm, but rather should drive you to institute the old Zig Zigler adage, “Expect the best.  Prepare for the worst. And capitalize on whatever comes along.”

 

D. R. Barton, Jr. will be teaching the upcoming Professional Tactics of Day Trading Course, May 14-16, 2005, and Swing Trading  August 26-28 2005. 

He is the Chief Operating Officer and Risk Manager for the Directional Research and Trading hedge fund group. D. R. has been actively involved in trading, researching and teaching in the markets since 1986.  D. R. has taught extensively in many investment areas including intra-day trading, swing trading, and cutting edge risk management techniques. 

His writing credits include co-authoring Safe Strategies for Fin-ancial Fre-edom and co-creator and contributing author on Fin-ancial Fre-edom Through  Electronic Day Trading. He also writes a stock screening newsletter called Ten Minute Trader.

Listening in....

Excerpts from Dr. Tharp's Mastermind Discussion Forum

Tharp's Recommends 50k-100k to Start, But What About Forex? 
Author: Ezen

You will be paying that same amount of spread if you have 100k or if you have 1k(proportionally). So the capital size doesn't make a difference proportionally wise. Is forex the way to go for people who are starting out and need to learn without risking all their savings?
Or is it futures? (Even without being able to apply position sizing because your just buying one contract you will learn the psychological and system development aspects)
Thoughts?


Reply To This Message 

Re: Tharp's Recommends 50k-100k to Start, But What About Forex? 
Author: PMK

Ezen,

Although you are correct that a fixed spread when you are trading very small size is beneficial, I do not think that FX is the best market for beginners for the following reasons:

Firstly, going long EUR and short JPY, for example, is conceptually more difficult to grasp than buying IBM (say). If the base currency in your account is USD, then you not only have to consider the EUR/JPY exchange rate, but also the USD/EUR and USD/JPY rate and the effect on your position with respect to your base currency.

Secondly, you need to consider the interest rate differential between what you earn on the long currency and what you pay on the short currency (and the changes in these rates).

Thirdly, FX can only be traded in a margin account so you can't trade it in your retirement account (unless you use Currency Titures and I'm not going there right now :-), and you have to learn about currency margin requirements.

Fourthly, good data on exchange rates is less prevalent than other markets.

For a beginning trading system I would trade high-volume US Equities with enough cash so that I could trade at least one round lot (100 shares) without using margin. Since you are trading high-volume equities the spread should be tight, and if you trade at least 100 shares the commission should be no more than 1c/share, you don't have to consider interest rate differentials, the only price you care about is the price of the equity you are trading, and you don't have to know/worry about margin requirements or leverage. Once you have become competent at trading equities then you can move onto more exotic instruments.


Hope this helps

PMK 

Click  here to read more  responses to this post on Dr. Tharp's Forum. There were many great posts on this topic this week.

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