The Essentials of Trading

Information and resources to learn about trading and the markets

Taxes and Cutting Your Losers

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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.

Taxes, Budget Deficits and Inflation

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A couple of things have come out from different politicians the last couple days which have me shaking my head. File this under big picture macro fundamental anlysis, I suppose. I don’t normally offer up market analysis here, but it’s worth indicating the way one can approach market analysis.

Tax Hikes Leading to Inflation
The first is a statement yesterday by the governor of the Mexican central bank. In talking about forecasts for the year to come he expressed the view that tax hikes instituted in the latest budget could add 50bps (0.50%) to the annual inflation rate in 2010. I can only pressume that he means said tax cuts will somehow filter through into higher consumer prices as a pass on effect.

Now I don’t know the specifics of the tax hikes in question, so I can’t speak directly to the type of pass-along effect there might be and from what directions. I seriously doubt it would ever be a 100% pass through from producers to consumers, and some of the hikes may directly hit comsumers, which wouldn’t be involved in price levels at all. In other words, I have lots of questions about how much pass-along there is likely to be.

On top of that, there are two other elements to the inflation equation. To the extend that pass-along taxes increase prices and/or taxes directly impact consumer it will lower demand. That would tend to put downside pressure on prices. Furthermore, when the government increases taxes it pulls more money out of the system, reducing money supply. If inflation is at least partly a function of money supply, then taxes tend to be a depressive factor rather than an expansionary one.

Government Budget Deficitis of 3%
US Treasury Secretary Geithner was on CNBC this morning talking about the plan to get the US budget deficit down to 3% of GDP with the work on getting it down there starting in 2011. The EU finance ministers set similar targets for several members to reach by 2012-2015. So in other words, the world’s major economies will still be running budget deficits for quite a few more years to come.

Why is this important? Because one of two things have to happen. Either more sovereign debt (Treasuries, Gilts, Bunds, JGBs, etc) have to be issued or the monetary base will expand by the amount of those unborrowed deficits. In the latter case you get inflationary pressures. In the former you get lots more supply of debt instruments. Both tend to equate to higher interest rates over time.

Now if all countries are running deficits and not issuing debt to offset then everyone will see inflationary pressure, but it will tend to be cancelled out in the forex exchange rates. Things like commodities (think gold and oil), however, would tend to see price appreciation.

Avoiding a Covered Call Being Called

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A former classmate of mine from my undergraduate days (he and I were officers for the Finance Club once upon a time) sent me a question about option trading.

I want to get your thoughts on something – A covered call option that I wrote is now at the money with expiration in Jan. I planned to sell it in the new year so this is fine. Logically, it shouldn’t be exercised early but I’m not sure it will hold in practice? So, if the option is exercised early will I have a chance to settle for cash? or buy an offsetting option or the shares? It’s a big gain and selling the shares now means a big tax bill in 2010, that I’d prefer to hold off another year.

Now, I’m sure our derivatives professor will be disappointed that he doesn’t remember all the stuff he learned, but that was nearly 20 years ago, so I think some slack can be cut at this point. 🙂

Just for quick clarification for those not in the know, a covered call strategy is one in which a person holding stock (or futures, etc.) writes/sells a call option against their position. It’s a type of yield enhancement strategy in that selling the option provides a bit of income. Of course there are limitations and caveats. I won’t go too far into them here, though.

The concern of my classmate is about the stock being called from him prior to year-end. The option strike is clearly above his purchase price, meaning were he forced to sell it to the holder of the option he would have a gain to be booked, and thus a tax liability. He’d rather avoid that happening until into 2010.

Now options are very rarely excercised early because it generally doesn’t make sense to do so. The only time early exercise pays off is if there is no time value left on the option, implying the option is trading at or below intrinsic value. That basically never happens.

Of course you cannot be 100% sure an option won’t be exercised, which is my classmate’s concern. The problem, however, is that you can’t cancel out exercise risk all together without buying back that option. He could reduce the prospects for an unwanted exercise by rolling to a further out option and/or to a further out of the money strike, but any alternate strategy would still require buying back the original option in order for the exercise risk to be reduced.

But this does bring up an important point. As traders we often don’t give a lot of thought to the tax consquences of what we do, focusing instead mainly on attempting to generate profits (can’t tax what you don’t make). Sometimes, though, it makes sense to take a look at the tax implications of things.

Help With Trading Taxes

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I had this question come in yesterday regard finding a tax professional to help with trading related issues.

Hi John,

I have started trading several times a day now and am in need of a good tax person here in Orange County – I made 30 fruitless calls and wasted 2 hours in Irvine yesterday – no-one knows much about mark-to-market elections, wash sale rule or trading strategies.

Is there anyone you could recommend or could you suggest how I could locate a good tax person?

Thanks for a good website!

Regards,

Peter

I don’t personally know any tax professionals in Orange County (that’s Southern California near Los Angeles for those not in the geographic know 🙂 ), but I know some readers of this blog are from that area. If you happen to know someone Peter might be able to use, please let me know and I will pass the info along.

Now, in general terms there is a group who’s focus is on taxation related to traders. That’s www.tradersaccounting.com. I have never dealt with them, so I can’t provide any specific referral information here. I just found them while looking around on the web some time back. One of these days I would like to get someone from there to do some kind of educational thing for my mailing list, but I haven’t gotten around to making the inquiries yet.

If you happen to have any feed back on Traders Accounting or any other group, or anything else related to tax preparation for US traders (in this case), please leave a comment and let us know.

Motley Fool Acting the Part

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I recently had the opportunity to pick up a free copy of the latest Motley Fool book, Million Dollar Portfolio. I’ve never spent much time looking at what the folks at Motley Fool do, though I know their focus is on stock investing. With that and the idea that I could provide my readers with a review of the book when I finished, I decided to go ahead and get it.

I’ve only just started reading Million Dollar Portfolio as part of my daily commute. It will probably take a little while to get all the way through, so you’ll have to wait for a the full review until then.

There is one little thing I need to comment on, however.

At the start of the third chapter, in classic investor book fashion, the authors attempt to demonstrate why a buy-and-hold approach beats a trading approach. Taxes and transaction costs are the noted culprits which make trading much less worthwhile than investing.

Here’s the problem, though.

The example they use is so completely erroneous as to be farcical.

A scenario is offered in which you can either invest $1000 in a stock which makes 7% per year, or you can use that $1000 to play one stock each year that makes 12% per annum. Transaction costs are $10 per side. Short-term capital gains taxes in the U.S. are 15%. Long-term capital gains taxes are not listed, but are said to be higher. The authors claim that the 7% option turns the initial into $6137, while the 12% option actually only gets you up to $3073 after all the transaction costs and taxes which come out along the way.

Seems like a pretty good argument for investing, doesn’t it?

It’s a complete crock!

The numbers don’t work out at all. All we have to do is look at where each portfolio is at after one year to see the error.

At the end of the first year the 7% portfolio is worth $1070 ($1000 x 7%). Actually, if we take out the $10 commission for buying that $1000 worth of stock the real value is $1060.

Where the 12% portfolio value is at in one year depends on the short-term capital gains tax rate. That year’s trade will make $120 ($1000 x 12%). We need to take out $20 for transaction fees, so that leaves a $100 profit. Now, if the tax rate is more than 40%, then the 12% portfolio ends up with a final value lower than than the 7% one. At 40% the two are the same. Any tax rate lower than that the 12% portfolio is the winner.

A little investigating indicates that the top end U.S. short-term capital gains rate is 35%. My calculations indicate that at such a rate the 12% portfolio would end up with a final value close to $9000. That’s considerably better than the $6137 the authors indicate would be the final value of the 7% portfolio (though my calculations put it somewhere closer to $6500).

On top of this funky math, they get even more ridiculous.

Motley FoolThe Motley Fools cite a report from Charles Schwab which says that short-term traders need to make 21.2% more than the longer-term ones to offset the taxes. Somehow they translate this figure to mean it would take a 48% annual pre-tax return to better the 7% portfolio’s results. I really don’t know where they pulled that number from. It clearly, though, has no basis in reality.

I’m not arguing here against the overall contention that longer-term traders have lower transaction cost and capital gains hurdles to overcome. They most certainly do. Traders need to be pretty sure they are going to considerably exceed the returns they would expect to get from a buy-and-hold strategy in order to make trading worth their while. I just have really hard time respecting the conclusions put forward by someone who is so painfully off in constructing their arguments.

Do you have any thoughts about or experience with Motley Fool?