Categories
The Basics

Taxes and Cutting Your Losers

I’ve been doing quite a bit of reading on the subject of Behavioral Finance of late (and will only being doing more and more in the future). I haven’t been in the academic finance arena since I did my MBA in the late 90s, so some of what I’m going it refreshing my knowledge base and reaquainting myself with the academic viewpoint. It’s really easy to slip away from that when you’re focused very closely on real world markets and regularly interacting with real-world traders, not just the ones imagined in the academic literature. (On the Behavioral Finance subject, I encourage you to watch Mind Over Money.)

One of the things that has come up fairly frequently in the articles and papers I’ve been reading is the idea of cutting your losses and letting your profits run. Now this is an academic discussion, so it has relatively little to do with what most traders think when that sort of advice is being offered. Instead, the academics are referring to the tax implications, especially since they most often are referring to stock trading/investing.

Here’s the logic
When you close a position you trigger a tax event. If you exit a profitable position you’ll have a tax liability – obviously – so it behooves one to hold on as long as possible to defer that event. This is particularly true near year-end when a shortly extended holding period can defer a tax bill by 12 months or more.

As for cutting your losses early, that’s the flip side. When you take a loss you reduce your tax liability. That means it behooves you to book your losses quickly. In effect, the tax impact reduces your net loss. For example, if you’re tax rate is 20% and you’ve taken a $1000 trading loss, you’ve effectively only lost $800. In other words, your account is effectively worth $200 more if you take that loss than if you hold on to the trade. The academics I’ve read seem genuinely incredulous that traders and investors would hold losing positions for exactly that reason.

Know the Law
Now there are all kinds of different tax rules in the global array of jurisdictions and markets. For example, in the US securities (stocks, bonds, options, etc.) fall under normal capital gains where the tax impact is only felt when a trade is closed. Futures and forex are treated differently in that your positions are marked-to-market at year-end. That means the timing of your exits doesn’t really matter. The rules are different in other countries, though, especially when you bring in things like spreadbetting, so make sure you know how your country’s tax laws impact your bottom line.

By John

Author of The Essentials of Trading

4 replies on “Taxes and Cutting Your Losers”

John,

Academics serve a purpose and can collect and analyze a large amount of data. However, they are not traders. They do not understand the trader mindset, and they completely ignore risk.

Holding a trade to delay paying taxes is stupid. That adds extra risk to the trade – and yes, it may also add reward potential. However, when it’s time to cut losses or take profits or exit a trade for any risk-based reason, then stalling is the hallmark of a novice.

I love to pay taxes, and wish they were $1,000,000 per year. Why is everyone against paying taxes? But more than that, who is his right mind would take significant market risk to delay paying them?

Mark – You are of course correct. I held back from addressing the trading reasons for holding or not holding a position just to see if I could get someone to react. Congratulations! You win. 🙂

That said, there are certainly opportunities to employ option strategies to allow one to exit a trade from one perspective but maintain the desired exposure from another. Sounds like the makings of a blog post. 🙂

John,

There are rules that prevent substituting ‘essentially the same’ position for another. The IRS is not dumb on this issue.

However, I’ve never looked into this and don’t know how easy it would be to be a find a good ‘substitute’ that passes IRS scrutiny.

A post for a tax expert perhaps. Not for me.

Regards

I’d argue that doing an option spread after closing a stock position (or vice versa) doesn’t fulfill the “substantially identical” criteria, but clearly anyone looking to do something like that would want to consult with an expert.

Leave a Reply

Your email address will not be published. Required fields are marked *