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Path: senator-bedfellow.mit.edu!dreaderd!not-for-mail Message-ID: <investment-faq/general/part16_1082200966@rtfm.mit.edu> Supersedes: <investment-faq/general/part16_1079601013@rtfm.mit.edu> Expires: 31 May 2004 11:22:46 GMT References: <investment-faq/general/part1_1082200966@rtfm.mit.edu> X-Last-Updated: 2003/03/17 From: noreply@invest-faq.com (Christopher Lott) Newsgroups: misc.invest.misc,misc.invest.stocks,misc.invest.technical,misc.invest.options,misc.answers,news.answers Subject: The Investment FAQ (part 16 of 20) Followup-To: misc.invest.misc Summary: Answers to frequently asked questions about investments. Should be read by anyone who wishes to post to misc.invest.* Organization: The Investment FAQ publicity department Keywords: invest, finance, stock, bond, fund, broker, exchange, money, FAQ URL: http://invest-faq.com/ Approved: news-answers-request@MIT.Edu Originator: faqserv@penguin-lust.MIT.EDU Date: 17 Apr 2004 11:28:38 GMT Lines: 1202 NNTP-Posting-Host: penguin-lust.mit.edu X-Trace: 1082201318 senator-bedfellow.mit.edu 569 18.181.0.29 Xref: senator-bedfellow.mit.edu misc.invest.misc:42160 misc.invest.stocks:840679 misc.invest.technical:101768 misc.invest.options:54803 misc.answers:17227 news.answers:270009 Archive-name: investment-faq/general/part16 Version: $Id: part16,v 1.61 2003/03/17 02:44:30 lott Exp lott $ Compiler: Christopher Lott The Investment FAQ is a collection of frequently asked questions and answers about investments and personal finance. This is a plain-text version of The Investment FAQ, part 16 of 20. The web site always has the latest version, including in-line links. Please browse http://invest-faq.com/ Terms of Use The following terms and conditions apply to the plain-text version of The Investment FAQ that is posted regularly to various newsgroups. Different terms and conditions apply to documents on The Investment FAQ web site. The Investment FAQ is copyright 2003 by Christopher Lott, and is protected by copyright as a collective work and/or compilation, pursuant to U.S. copyright laws, international conventions, and other copyright laws. The contents of The Investment FAQ are intended for personal use, not for sale or other commercial redistribution. The plain-text version of The Investment FAQ may be copied, stored, made available on web sites, or distributed on electronic media provided the following conditions are met: + The URL of The Investment FAQ home page is displayed prominently. + No fees or compensation are charged for this information, excluding charges for the media used to distribute it. + No advertisements appear on the same web page as this material. + Proper attribution is given to the authors of individual articles. + This copyright notice is included intact. Disclaimers Neither the compiler of nor contributors to The Investment FAQ make any express or implied warranties (including, without limitation, any warranty of merchantability or fitness for a particular purpose or use) regarding the information supplied. The Investment FAQ is provided to the user "as is". Neither the compiler nor contributors warrant that The Investment FAQ will be error free. Neither the compiler nor contributors will be liable to any user or anyone else for any inaccuracy, error or omission, regardless of cause, in The Investment FAQ or for any damages (whether direct or indirect, consequential, punitive or exemplary) resulting therefrom. Rules, regulations, laws, conditions, rates, and such information discussed in this FAQ all change quite rapidly. Information given here was current at the time of writing but is almost guaranteed to be out of date by the time you read it. Mention of a product does not constitute an endorsement. Answers to questions sometimes rely on information given in other answers. Readers outside the USA can reach US-800 telephone numbers, for a charge, using a service such as MCI's Call USA. All prices are listed in US dollars unless otherwise specified. Please send comments and new submissions to the compiler. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Tax Code - Non-Resident Aliens and US Holdings Last-Revised: 26 Jan 2003 Contributed-By: Vladimir Menkov (vmenkov at cs.indiana.edu), Chris Lott ( contact me ), Enzo Michelangeli (em at who.net) Non-resident aliens can hold investments in the United States quite easily. A "non-resident alien" (NRA) is the U.S. government's name for a citizen of a country other than the U.S. who also lives outside the U.S. The only thing non-resident aliens have to be concerned about if they have U.S. investments is taxation. For example, if a non-U.S. national works in the U.S. for some period of time and amasses a nice portfolio of stocks while here, that person can hang on to the portfolio forever, no matter whether they continue to live in the U.S. or not. But they will have to continue to deal with the U.S. tax authority, the IRS. Thanks to the U.S. Congress, the tax laws are complicated, and a resident or nonresident alien must look carefully to find a tax advisor who understands all the issues. Here's an overview. A person is considered non-resident in the years when that person is in the US fewer than 183 days; the actual rule is a little more complex, and takes prior years into account; see IRS publication 519 for details. Anyhow, in the years when a non-US citizen is considered a non-resident for tax purposes, that person files the US tax return on form 1040 NR, instead of regular 1040 (EZ, A), and pays tax on investment income according to the following special rules. * No tax on capital gains. This means that a brokerage or a mutual fund should withhold nothing when selling shares. With respect to mutual funds, long-term capital gain distributions are exempt as well. * No tax on bank interest. This means regular accounts with credit unions, savings and loans, etc. * No tax on portfolio interest. (It's not always easy to figure out interest on what bonds qualifies as "portfolio interest", though. Some readers have reported that brokerage firms are confused on this issue, unfortunately.) * 30% flat-rate tax on dividends. Generally this includes dividend and short-term cap gain distributions by mutual funds. This rate may be reduced by a tax treaty with your country of residence. (Progressive taxation does not apply to NRAs; i.e., the first and last dollars are taxed at the same rate.) * 30% flat-rate tax on interest that neither is paid by a bank nor qualifies as "portfolio interest." This rate may be reduced by a tax treaty with the person's country of residence. * No personal exemption or deductions can be applied against investment income (which is, technically, "income not effectively connected with your US trade or business"). Further, according to the IRS, "if your sole U.S. business activity is trading securities through a U.S. resident broker or other agent, you are not engaged in a trade or business in the United States" so the income is not effectively connected with a US trade or business. * If the alien is a non-resident for the tax purposes in a given year, but spends 183 days or more in the country, any capital gains are also subject to the 30% flat tax. This is a fairly rare but possible situation. The issue of an investment paying dividends versus paying interest is simple in case of stocks (dividends) and basic savings accounts (interest), but what about money market accounts? Well, money-market mutual funds pay dividends , while money-market bank accounts pay interest , for the purposes of 1040 NR. However, if you have a money market fund with a bank and the bank reports the income as dividends, it is probably simplest to report the income exactly as the institution reported it rather than try to fight it. I don't know why this isn't straightforward, but for some reason it is not. For more information, see IRS Publication 550, "Investment Income and Expenses." In the 2000 edition, the relevant language appears in the first column of page 5, in the section "Interest Income," subsection "Taxable Interest - General." Tax treaties are very important. If the individual's country of residence has an agreement (tax treaty) with the US government, those rules pretty much supersede the standard rules set by the Internal Revenue Code. In particular, they often reduce the tax rate on interest and dividend income. While you are a non-resident alien, you are supposed to file Form W-8BEN (it replaces older Forms W-8 and 1001) with each of your mutual funds or brokers every 3 or 4 years, so that they will automatically withhold tax from your investment income. Since you have to indicate your country of residence for tax purposes on this form, the investment income payor will know what tax treaty, if any, applies. In the spring, the payor will send you a form 1042-S reporting your income, its type, and the tax withheld. If Forms W-8BEN have been filed and the appropriate tax has been withheld, you won't need to send any money to the IRS with your 1040 NR in April; in fact, you won't even need to file 1040 NR at all if you don't have other US-source income. Note also that as a non-resident you will not be eligible to claim standard deduction, or to claim married status, or file form 1116 (foreign tax credit). The IRS enacted some rules in late 2000 to establish "Qualified Intermediary" status for foreign financial institutions. The rules did not change tax liabilities, just made it more difficult for a person to escape paying tax. To summarize, a financial institution must withhold money from payments of US-source income to individuals outside the US unless the institution qualifies for the newly introduced status of "qualified intermediary", or unless the institution agrees to disclose the list of all beneficiaries to the IRS. A financial institution is eligible to apply for qualified intermediary status if it is in a country that has been approved by the IRS as having acceptable 'know-your-customer' rules. None of this discussion applies to resident aliens or to US citizens living abroad. Once you are considered a bona fide resident of the U.S., the tax rules that apply to U.S. citizens also apply to you. Here are some IRS resources that offer all the details: * IRS Publication 515, "Withholding of Tax on Non-Resident Aliens" http://www.irs.gov/forms_pubs/pubs/p515toc.htm * IRS Publication 519, "U.S. Tax Guide for Aliens" http://www.irs.gov/forms_pubs/pubs/p519toc.htm * IRS Publication 901, "Tax Treaties" http://www.irs.gov/forms_pubs/pubs/p901toc.htm * IRS Tax Topic 851, "Resident and Nonresident Aliens" http://www.irs.ustreas.gov/prod/tax_edu/teletax/tc851.html * The IRS web site "Digital Daily" has a collection of information for the International Taxpayer. http://www.irs.gov/businesses/small/international/ * The Digital Daily's area includes this article which focuses on the taxation of capital gains Of nonresident aliens (the link is unfortunately buried in another article). http://www.irs.gov/businesses/small/international/article/0,,id=96400,00.html --------------------Check http://invest-faq.com/ for updates------------------ Subject: Tax Code - Reporting Option Trades Last-Revised: 16 Aug 2000 Contributed-By: Michael Beyranevand (mlb2 at bryant.edu) This article summarizes the rules for reporting gains and losses from trading stock options. Like any other security transaction, even if you get cash up front as in the case of shorting a stock or writing an option, you do not declare a profit or loss until the transaction has been closed out. Also note that ordinary options expire in 6 months or less, so most gains or losses are short-term (but see below for an exception in the case of writing covered calls). However, LEAPS can have a lifetime of over 2 years (also see the article elsewhere in this FAQ ), so gains or losses might be long-term for the purpose of the tax code. Buyers of Options There are three different tax treatments that could occur when you decide to buy a put or call option. The first is that you reverse your position (sell the option) before the exercise date. If this is the case, then you will have either a short-term (if held for under 1 year) or long-term (if held for more than 1 year) capital gain/loss to report. The second tax treatment occurs if you allow the option to expire unexercised. It would then be treated as either a short-term or long-term loss based on the holding period of the option at the expiration date. The third tax treatment for buying options occurs when you decide to exercise either your put or call option. If you exercise your call (the right to buy stock) you add the cost of the call to the cost basis of your stock. If you exercise a put (the right to sell stock) then the cost of the put reduces your total amount realized when figuring gain or loss on the sale of that stock. Sellers of Options There are also three tax treatments that could occur when you sell a put or call option. The first possibility is that you reverse your position on an option that you wrote. Then it would become either be a short-term gain or loss. The difference between what you sold it and bought it back at will determine the gain/loss status. The second possibility is that the option expires (it is not exercised before the expiration date). In this scenario you would report the premium received as a short-term capital gain in the year the option expires. The third situation is when the option is exercised (you are called or put). In the case of a call, you add the premium to the sale proceeds of the stock to determine a gain or loss on the sale of the stock. The holding period of the stock (not the option!) will determine if the gain is short term or long term. So if it was a covered call, it might be short or long term. If it was a naked call, the holding period will be brief (minutes?) and so it's a short-term gain. In the case of a put that is exercised, the tax situation is significantly more complex as compared to a call. To determine if the premuim counts as income when the put is exercised or if it just lowers the cost basis of the stock is determined by many factors, just one of which is whether the put was in the money or out of the money when it was written, and to what extent. Novice put writers should consult with a professional tax advisor for assistance. For the last word on the tax implications of trading options, get IRS Publication 550, _Investment Income and Expenses_. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Tax Code - Short Sales Treatment Last-Revised: 13 Aug 1999 Contributed-By: Art Kamlet (artkamlet at aol.com), Chris Lott ( contact me ) Gains from a short-sale stock transaction are considered short-term capital gains regardless of how long the position is held open. This actually makes a kind of sense, since the only time you actually held the stock was between when you bought the stock to cover the position and when you actually delivered that stock to actually close the position out. This length of time is somewhere from minutes to a few days. (Please see articles elsewhere in this FAQ explaining short sales, as well as long- and short-term capital gains.) What do you do if a short sale is open at the end of a calendar year? Brokerage houses report all sales (normal or short) on Form 1099-B as "sales", so you might think that you have to report it on your Schedule D to make the total sales number equal that reported to the IRS. But since the position is still open, the sale was not a taxable event. You sure don't want to pay tax on the amount of money you received when you went short! Here's one way to proceed. You can attach a statement along the following lines to your Schedule D: Attachment to 1998 Form 1040 Schedule D (Names & Social security #) Explanation of the difference between Forms 1099-B and Schedule D Sales totals: Forms 1099-B include $XXXX of short sales which were opened in 1998 and remained open on 31 December 1998. Forms 1099-B Totals: $YYYY less short positions opened during 1998 remnaining open 12/31/98 ( $XXXX ) _______ Adjustment (if any) $WWWW ________ Schedule D Sales Totals $ZZZZ Note that when the short positions are finally closed out, the brokerage house will not make any indication on that year's 1099-B, but that's the year when you have to report the gains or losses realized in the transaction. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Tax Code - Tax Swaps Last-Revised: 12 Aug 1996 Contributed-By: Bill Rini (bill at moneypages.com), and other anonymous contributors A tax swap is an investment strategy usually designed for municipal bond portfolios. It is designed to allow you to take a tax loss in your portfolio while at the same time adjusting factors such as credit quality, maturity, etc. to better meet your current needs and the outlook of the market. A tax swap can create a capital loss for tax purposes, can maintain or enhance the overall credit quality of your portfolio, and can increase current income. It's important to note that tax swaps are not for everyone. And as always, you should consult with a tax professional before making any investment desicion that is designed to produce tax benefits. Here is an example of a hypothetical tax swap. I have not factored accrued interest to keep the calculations fairly simple. Current Bond - You will sell this bond to generate a capital loss. $10,000 par value "ABC" Tax Free bond, A rated, with a coupon of 4.70%. maturing 09/01/03 originally purchased for $10,000 (100) but with a current market value of only $9030 (90.30). Replacement Bond - The bond you will buy to replace your current bond. $10,000 par value "XYZ" Tax Free bond, AAA rated, with a coupon of 5.20% maturing 12/01/12 The current selling price of this bond is $8724 (87.24) Sell "ABC" Bond $9030.00 Buy "XYZ" Bond $8724.00 -------- Difference: $306.00 The tax swap accomplished the following. First, you received $306.00 cash. Second, you upgraded the credit quality of your single-bond portfolio from A to AAA. Third, you generated a capital loss of $970.00 (original purchase price minus the selling price). Fourth, you've increased the bond's maturity and coupon, so its duration will be greater. This swap will increase the portfolio's sensitivity to interest rate changes, which may or may not be what the investor had in mind. In particular, it might be not appropriate for a short-term investment. If the bond is held to maturity, then no risk is assumed other than default risk. (Although unrealized value would change wildly, and perhaps that's taxable in some circumstance). Portions of this article are copyright 1995 by Bill Rini. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Tax Code - Uniform Gifts to Minors Act (UGMA) Last-Revised: 15 Feb 2001 Contributed-By: Art Kamlet (artkamlet at aol.com), Aaron Schindler, Mark Eckenwiler, Brian Mork, Rich Carreiro (rlcarr at animato.arlington.ma.us) The Uniform Gifts to Minors Act (UGMA), called the Uniform Transfers to Minors Act (UTMA) in some states, is simply a way for a minor to own securities. The UGMA/UTMA setup is commonly used to give monies to a minor. IRS regulations allows a person to give many thousands of dollars per year to any other person with no tax consequences (please see the FAQ article on Estate and Gift Tax for current numbers). If the recipient is a minor, the UGMA provides a way for the minor to own the assets without involving an attorney to establish a special trust. When giving assets to a minor using a UGMA/UTMA, the donor must appoint a custodian (the trustee). An UGMA/UTMA is a trust like any other trust except that the terms of the trust are set in the state statute instead of being drawn up in a trust document. Should a trustee fail to comply with the terms of the UGMA/UTMA, this would expose the trustee to the same actions as a trustee who fails to comply with the terms of a special drawn-up trust. Why is a UGMA useful? The UGMA/UTMA offers a straightforward way for a minor to own securities. In most (all?) states, minors do not have the right to contract. So a minor could not be bound by any broker's account agreement. If a broker took a minor's account, the minor, upon reaching majority, could repudiate any losing trades and make the broker eat them. Thus brokers and fund companies once refused to take minor's accounts. UGMA/UTMA was basically a way of providing a form of ownership that got around this problem, without forcing people to go through the expense of having an attorney draw up a special trust. To establish a UGMA/UTMA account, go to your friendly neighborhood stockbroker, bank, mutual fund manager, or (close your eyes now: S&L), etc. and say that you wish to open a Uniform Gifts (in some states "Transfers") to Minors Act account. You register it as: [ Name of Custodian ] as custodian for [ Name of Minor ] under the Uniform Gifts/Transfers to Minors Act - [ Name of State of Minor's residence ] You use the minor's social security number as the taxpayer ID for this account. When you fill out the W-9 form for this account, it will show this form. The custodian should certify the W-9 form. The money now belongs to the minor and the custodian has a legal fiduciary responsibility to handle the money in a prudent manner for the benefit of the minor. Handling the money "in a prudent manner" means that the custodian can buy common stocks but cannot write naked options. The custodian cannot "invest" the money on the horses, planning to donate the winnings to the minor. And when the minor reaches the age at which the UGMA becomes property of the minor (who is either 18 or 21 depending on the state and not a minor any loger), the minor can claim all of the funds even if that's against the custodian's wishes. Neither the donor nor the custodian can place any conditions on those funds once the minor becomes an adult. You may be concerned about preventing a minor from blowing the college fund on a Trans Am the moment the minor attains the turnover age and the money is under their control. Legally there is nothing the custodian (or anyone else) can do. Some may sugggest that a UGMA account can be hidden from a minor, but this is a problem for two reasons. First, any minor over age 14 is expected to sign his or her tax return and thus has a good chance to notice the income from the account. Second and more seriously, if the custodian fails to turn over money that is due to the UGMA beneficiary, he or she breaches the statutory trust terms and is liable for the consequences of that failure, just as any other trustee would be, which may include surcharges and other sanctions from a court. If it is any consolation, some states allow the donor to establish a "turnover" age of 21 (instead of the default 18) by making an express statement to that effect when the account is created. In other states, the turnover age is 21 by default, and an express statement is required to establish a lower turnover age. The trustee can transfer funds between UGMA/UTMA accounts at will. For example, this might be attractive if a UGMA seems to be underperforming similar type accounts or if it lacks the services of other UGMA accounts such as online access. The custodian is managing the funds on behalf of the minor, and part of management is deciding where to place the funds and with which bank, broker, or other fiduciary. The custodian must be certain to maintain a paper trail showing that every dollar withdrawn from one account was transferred to another account. If the UGMA account is with a broker or mutual fund manager, and a transfer is desired, contact the new broker or manager and they will arrange all the paperwork for a direct transfer. Given all the warnings above, there is a way to give money to a minor and restrict the minor's access until you feel he or she is ready. The mechanism is not a UGMA, however, but another sort of trust. Contact American Century Investments for information about their GiftTrust fund. The fund is entirely composed of trusts like this. The trust pays its own taxes. Unfortunately, this company may not keep the trust as quiet as you would like. When opening a Gift Trust, confirmation is sent to the donor, but in their words, "Subsequent confirmations are sent to the beneficiary's address." Further, they insist that Form 709 must be filed, it's a future interest and does not qualify for 10,000 exclusion; taxes must be paid now or consume part of lifetime $600,000 exemption. A future interest is just what it says: an interest in something that a person does not own until some time in the future. The American Century GiftTrust is an example of that. I believe the terms of the account state that money cannot be taken out of the account for any reason (except death of beneficiary) until the account has been open for at least 10 years. So the beneficiary does not actually truly own the assets until some time in the future. However, in certain situations, the *dis*qualified exemption of a future interest doesn't apply. In other words a Form 709 is *sometimes* not necessary and the lifetime $600K (which is crawling upwards these days) isn't dented. The IRS regs list these disqualifications of the disqualifications (don't you just love tax law?). In contrast, a minor is considered to own (though he or she does not control) the assets of an UGMA/UTMA account from the second assets are placed into the account -- the assets can be used for his or her benefit immediately. Therefore, gifts to an UGMA/UTMA are gifts of a present interest and do qualify for the $10,000 annual gift exclusion. With respect to gifts of a future interest (that are not eligible for the $10K annual exclusion) or for gifts that are eligible but are over $10K, a donor does not have the choice between paying gift tax and using up some of his or her unified credit. The donor is required to use unified credit first, only paying the gift tax once the unified credit is exhausted. See the article elsewhere in this FAQ on estate and gift taxes for more information. Note that if the trustee acts in such a way as to give the IRS cause to believe that no true gift was ever actually made, the IRS takes the position that no gift was made and taxes all the income to the parent instead of to the minor. But this is not unique to UGMA/UTMA. On a related note, some accountants advise that one person should make the gift and that a different person should be the custodian. The reason is that if the donor and custodian are the same person, that person is considered to exercise sufficient control over the assets to warrant inclusion of the UGMA in his/her estate. For more info, see Lober, Louis v. US, 346 US 335 (1953) (53-2 USTC par. 10922); Rev Ruls 57-366, 59-357, 70-348. All of these are cited in the RIA Federal Tax Coordinator 2d, volume 22A, paragraph R-2619, which says (among other things) "Giving cash, stocks, bonds, notes, etc., to children through a custodian may result in the transferred property being included in the donor's gross estate unless someone other than the donor is named as custodian." Finally, a word about taxes. Income that accrues to a minor, such as income from a UGMA account, is taxed as follows in tax year 2000. Assuming the child has no other income and is under age 14, the first $700 of investment income falls into the child's zero bracket. The next $700 is taxed at 15%, and the rest is taxed at the parents' top bracket . (The expected numbers for tax year 2001 are both $750.) The tax on a child's income imposed at the parents' top bracket is the so-called "kiddie tax." If the child is 14 or over, the parent's tax situation does not come into play at all. All the income is on the child's return and he or she is taxed as an entity unto himself/herself. Always check the Form 1040 instructions for the appropriate number to use for a given tax year. Also note that IRS regulations require all minors 14 or older to sign their own tax returns. Finally, please note that these tax rules are for earned and unearned income for a minor; there is no special tax treatment for UGMA accounts. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Tax Code - Wash Sale Rule Last-Revised: 11 Mar 2000 Contributed-by: Art Kamlet (artkamlet at aol.com), Rich Carreiro (rlcarr at animato.arlington.ma.us) A "wash sale" describes the situation in which you sell shares of some security at a loss, and within 30 days you purchase substantially identical securities. At face value, it looks like you took a loss on an investment (would would be deductible from your gross income when you do your taxes), yet you still own that investment, you just now have a lower cost basis. Unfortunately, the IRS does not consider the loss resulting from such a transaction to be deductible. If a sale is considered to be a wash sale, the loss cannot be treated as a capital loss on your federal tax return. In fact, the cost basis of the securities purchased is increased by the amount of that disallowed loss. The goal is to prevent someone from converting a paper loss into a real loss while actually hanging onto that same position. For the word from the horses mouth, here's a quote from IRS publication 550, "Investment Income and Expenses" (1990), p. 37: Wash Sales: You cannot deduct losses from wash sales or trades of stock or securities. However, the gain from these sales is taxable. A wash sale occurs when you sell stock or securities at a loss and within 30 days before or after the sale you buy or acquire in a fully taxable trade, or acquire a contract or option to buy, substantially identical stock or securities. If you sell stock and your spouse or a corporation you control buys substantially identical stock, you also have a wash sale. You add the disallowed loss to the basis of the new stock or security. This rule includes normal purchases followed by sales (i.e., you go long, then sell at a later date) as well as short sales and later purchases. Here's an extended example that may help clarify how the math must be done. The rule is actually rather simple, but when lots of trades are involved it can lead to very complicated situations. 1. 4/01/99 bought 100 at 120. 2. 5/01/99 sold 100 at 110 The loss was 10 x 100 = $1000. 3. 5/02/99 bought 100 at 95. Causes a wash sale of loss on 5/01/99. 4. 5/03/99 sold 100 at 100. The gain was 5 x 100 = $500, but you must add the wash sale $1000 into the basis of the purchase on 5/02/99, therefore this turns into a loss of $500. 5. 5/10/99 bought 100 at (any price). The sale on 5/03/99 is considered a wash sale even though it became a loss by adding in a wash sale from a previous sale. Stated differently, wash sales can create subsequent wash sales. The IRS publication goes on explaining all those terms (substantially identical, stock or security, ...). It runs on several pages, too much to type in. You should definitely call IRS for the most updated ones for detail. Phone number: 800-TAX-FORM (800-829-3676). Or visit their web site at http://www.irs.ustreas.gov --------------------Check http://invest-faq.com/ for updates------------------ Subject: Technical Analysis - Basics Last-Revised: 27 Jan 1998 Contributed-By: Maurice Suhre, Neil Johnson The following material introduces technical analysis and is intended to be educational. If you are intrigued, do your own reading. The answers are brief and cannot possibly do justice to the topics. The references provide a substantial amount of information. First, the references; the links point to Amazon, where you can buy the books if you're really interested. 1. John J. Murphy Technical Analysis of the Futures Markets 2. Martin J. Pring Technical Analysis Explained 3. Stan Weinstein Stan Weinstein's Secrets for Profiting in Bull and Bear Markets Now we'll introduce technical analysis and explain some commonly mentioned aspects. 1. What is technical analysis? Technical analysis attempts to use past stock price and volume information to predict future price movements. Note the emphasis. It also attempts to time the markets. 2. Does it have any chance of working, or is it just like reading tea leaves? There are a couple of plausibility arguments. One is that the chart patterns represent the past behavior of the pool of investors. Since that pool doesn't change rapidly, one might expect to see similar chart patterns in the future. Another argument is that the chart patterns display the action inherent in an auction market. Since not everyone reacts to information instantly, the chart can provide some predictive value. A third argument is that the chart patterns appear over and over again. Even if I don't know why they happen, I shouldn't trade or invest against them. A fourth argument is that investors swing from overly optimistic to excessively pessimistic and back again. Technical analysis can provide some estimates of this situation. A contrary view is that it is just coincidence and there is little, if any, causality present. Or that even if there is some sort of causality process going on, it isn't strong enough to trade off of. A very contrary view: The past and future performance of a stock may be correlated, but that does not mean or imply causality. So, relying on technical analysis to buy/sell a stock is like relying on the position of the stars in the atmosphere or the phases of the moon to decide whether to buy or sell. 3. I am a fundamentalist. Should I know anything about technical analysis? Perhaps. You should consider delaying purchase of stocks whose chart patterns look bad, no matter how good the fundamentals. The market is telling you something is still awry. Another argument is that the technicians won't be buying and they will not be helping the stock move up. On the other hand (as the economists say), it makes it easy for you to buy in front of them. And, of course, you can ignore technical analysis viewpoints and rely solely on fundamentals. 4. What are moving averages? Observe that a period can be a day, a week, a month, or as little as 1 minute. Stock and mutual fund charts normally are daily postings or weekly postings. An N period (simple) moving average is computed by summing the last N data points and dividing by N. Moving averages are normally simple unless otherwise specified. An exponential moving average is computed slightly differently. Let X[i] be a series of data points. Then the Exponential Moving Average (EMA) is computed by: EMA[i] = (1 - sm) * EMA[i-1] + sm * X[i] where sm = 2/(N+1), and EMA[1] = X[1]. "sm" is the smoothing constant for an N period EMA. Note that the EMA provides more weighting to the recent data, less weighting to the old data. 5. What is Stage Analysis? Stan Weinstein [ref 3] developed a theory (based on his observations) that stocks usually go through four stages in order. Stage 1 is a time period where the stock fluctuates in a relatively narrow range. Little or nothing seems to be happening and the stock price will wander back and forth across the 200 day moving average. This period is generally called "base building". Stage 2 is an advancing stage characterized by the stock rising above the 200 and 50 day moving averages. The stock may drop below the 50 day average and still be considered in Stage 2. Fundamentally, Stage 2 is triggered by a perception of improved conditions with the company. Stage 3 is a "peaking out" of the stock price action. Typically the price will begin to cross the 200 day moving average, and the average may begin to round over on the chart. This is the time to take profits. Finally, the Stage 4 decline begins. The stock price drops below the 50 and 200 day moving averages, and continues down until a new Stage 1 begins. Take the pledge right now: hold up your right hand and say "I will never purchase a stock in Stage 4". One could have avoided the late 92-93 debacle in IBM by standing aside as it worked its way through a Stage 4 decline. 6. What is a whipsaw? This is where you purchase based on a moving average crossing (or some other signal) and then the price moves in the other direction giving a sell signal shortly thereafter, frequently with a loss. Whipsaws can substantially increase your commissions for stocks and excessive mutual fund switching may be prohibited by the fund manager. 7. Why a 200 day moving average as opposed to 190 or 210? Moving averages are chosen as a compromise between being too late to catch much move after a change in trend, and getting whipsawed. The shorter the moving average, the more fluctuations it has. There are considerations regarding cyclic stock patterns and which of those are filtered out by the moving average filter. A discussion of filters is far beyond the scope of this FAQ. See Hurst's book on stock transactions for some discussion. 8. Explain support and resistance levels, and how to use them. Suppose a stock drops to a price, say 35, and rebounds. And that this happens a few more times. Then 35 is considered a "support" level. The concept is that there are buyers waiting to buy at that price. Imagine someone who had planned to purchase and his broker talked him out of it. After seeing the price rise, he swears he's not going to let the stock get away from him again. Similarly, an advance to a price, say 45, which is repeatedly followed by a pullback to lower prices because a "resistance" level. The notion is that there are buyers who purchased at 45 and have watched a deterioration into a loss position. They are now waiting to get out even. Or there are sellers who consider 45 overvalued and want to take their profits. One strategy is to attempt to purchase near support and take profits near resistance. Another is to wait for an "upside breakout" where the stock penetrates a previous resistance level. Purchase on anticipation of a further move up. [See references for more details.] The support level (and subsequent support levels after rises) can provide information for use in setting stops. See the "About Stocks" section of the FAQ for more details. 9. What would cause these levels to be penetrated? Abrupt changes in a company's prospects will be reacted to in the stock market almost immediately. If the news is extreme enough, the reaction will appear as a jump or gap in prices. More modest changes will result, in general, in more modest changes in price. 10. What is an "upside breakout"? If a stock has traded in a narrow range for some time (i.e. built a base) and then advances above the resistance level, this is said to be an "upside breakout". Breakouts are suspect if they do not occur on high volume (compared to average daily volume). Some traders use a "buy stop" which calls for purchase when a stock rises above a certain price. 11. Is there a "downside breakout"? Not by that name -- the opposite of upside breakout is called "penetration of support" or "breakdown". Corresponding to "buy stops," a trader can set a "sell stop" to exit a position on breakdown. 12. Explain breadth measurements and how to use them. A breadth measurement is something taken across a market. For example, looking at the number of advancing stocks compared to declining stocks on the NYSE is a breadth measurement. Or looking at the number of stocks above their 200 day moving average. Or looking at the percentage of stocks in Stage 1 and 2 configurations. In general, a technically healthy market should see a lot of stocks advancing, not just the Dow 30. If the breadth measurements are poor in an advancing sense and the market has been advancing for some time, then this can indicate a market turning point (assuming that the advancing breadth is declining) and you should consider taking profits, not entering new long positions, and/or tightening stops. (See the divergence discussion.) 13. What is a divergence? What is the significance? In general, a divergence is said to occur when two readings are not moving generally together when they would be expected to. For example, if the DJIA moves up a lot but the S&P 500 moves very little or even declines, a divergence is created. Divergences can signify turning points in the market. At a major market low, the "blue chip" stocks tend to move up first as investors becoming willing to purchase quality. Hence the S&P 500 may be advancing while the NYSE composite is moving very little. Divergences, like everything else, are not 100 per cent reliable. But they do provide yellow or red alerts. And the bigger the divergence, the stronger the signal. Divergence and breadth are related concepts. (See the breadth discussion.) 14. How much are charting services and what ones are available? Commercial services aren't cheap. Daily Graphs (weekly charts with daily prices) is $465 for the NYSE edition, $432 for the AMEX/OTC edition. Somewhat cheaper for biweekly or monthly. Mansfield charts are weekly with weekly prices. Mansfield shows about 2.5 years of action, Daily Graphs shows 1 year or 6 months for the less active stocks. Of course there are many charts on the web. See the article elsewhere in the technical analysis section of this FAQ about free charts. S&P Trendline Chart Guide is about $145 per year. It provides over 4,000 charts. These charts show one year of weekly price/volume data and do not provide nearly the detail that Daily Graphs do. You get what you pay for. There are other charting services available. These are merely representative examples. 15. Can I get charts with a PC program? Yes. There are many programs available for various prices. Daily quotes run about $35 or so a month from Dial Data, for example. Or you can manually enter the data from the newspaper. 16. What would a PC program do that a charting service doesn't? Programs provide a wide range of technical analysis computations in addition to moving averages. RSI, MACD, Stochastics, etc., are routinely included. See Murphy's book [Ref 1] for definitions. Frequently you can change the length of the moving averages or other parameters. As another example, AIQ StockExpert provides an "expert rating" suggesting purchase or short depending on the rating. Intermediate values of the rating are less conclusive. 17. What does a charting service do that a PC doesn't? Charts generally contain a fair amount of fundamental information such as sales, dividends, prior growth rates, institutional ownership. 18. Can I draw my own charts? Of course. For example, if you only want to follow a handful of mutual funds of stocks, charting on a weekly basis is easy enough. EMAs are also easy enough to compute, but will take a while to overcome the lack of a suitable starting value. 19. What about wedges, exhaustion gaps, breakaway gaps, coils, saucer bottoms, and all those other weird formations? The answer is beyond the scope of this FAQ article. Such patterns can be seen, particularly if you have a good imagination. Many believe they are not reliable. There is some discussion in Murphy [ref 1]. 20. Are there any aspects of technical analysis that don't seem quite so much like hokum or tea leaf reading? The oscillator set known as "stochastics" (a bit of a misnomer) is based on the observation that a stock which is advancing will tend to close nearer to the high of the day than the low. The reverse is true for declining stocks. It compares today's close to the highest high and lowest low of the last five days. This indicator attempts to provide a number which will indicate where you are in the declining/advancing stage. 21. Can I develop my own technical indicators? Yes. The problem is validating them via some sort of backtesting procedure. This requires data and work. One suggestion is to split the data into two time periods. Develop your indicator on one half and then see if it still works on the other half. If you aren't careful, you end up "curve fitting" your system to the data. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Technical Analysis - Bollinger Bands Last-Revised: 12 Oct 2000 Contributed-By: John Bollinger (BBands at BollingerBands.com) While there are many ways to use Bollinger Bands, following are a few rules that serve as a good beginning point. 1. Bollinger Bands provide a relative definition of high and low. 2. That relative definition can be used to compare price action and indicator action to arrive at rigorous buy and sell decisions. 3. Appropriate indicators can be derived from momentum, volume, sentiment, open interest, inter-market data, etc. 4. Volatility and trend have already been deployed in the construction of Bollinger Bands, so their use for confirmation of price action is not recommended. 5. The indicators used should not be directly related to one another. For example, you might use one momentum indicator and one volume indicator successfully, but two momentum indicators aren't better than one. 6. Bollinger Bands can also be used to clarify pure price patterns such as "M" tops and "W" bottoms, momentum shifts, etc. 7. Price can, and does, walk up the upper Bollinger Band and down the lower Bollinger Band. 8. Closes outside the Bollinger Bands are continuation signals, not reversal signals. (This has been the basis for many successful volatility breakout systems.) 9. The default parameters of 20 periods for the moving average and standard deviation calculations, and two standard deviations for the bandwidth are just that, defaults. The actual parameters needed for any given market/task may be different. 10. The average deployed should not be the best one for crossovers. Rather, it should be descriptive of the intermediate-term trend. 11. If the average is lengthened the number of standard deviations needs to be increased simultaneously; from 2 at 20 periods, to 2.5 at 50 periods. Likewise, if the average is shortened the number of standard deviations should be reduced; from 2 at 20 periods, to 1.5 at 10 periods. 12. Bollinger Bands are based upon a simple moving average. This is because a simple moving average is used in the standard deviation calculation and we wish to be logically consistent. 13. Make no statistical assumptions based on the use of the standard deviation calculation in the construction of the bands. The sample size in most deployments of Bollinger Bands is simply too small for statistical significance. 14. Finally, tags of the bands are just that, tags not signals. A tag of the upper Bollinger Band is NOT in-and-of-itself a sell signal. A tag of the lower Bollinger Band is NOT in-and-of-itself a buy signal. For a free tutorial on Bollinger Bands, please visit http://www.BollingerBands.com/services/bb/intro.asp --------------------Check http://invest-faq.com/ for updates------------------ Subject: Technical Analysis - Black-Scholes Model Last-Revised: 10 Apr 1997 Contributed-By: Kevin Lee (kevsterdtn at aol.com) Black and Scholes are the mathmeticians who developed a model (formula) that determines theoretical value of an option based on volatility and time to expiration. Although this valuation is a theoretical value, it is essentially the industry standard. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Technical Analysis - Commodity Channel Index Last-Revised: 1 Apr 1997 Contributed-By: (anonymous), contact Chris Lott ( contact me ) The Commodity Channel Index (CCI) is a timing tool that works best with seasonal or cyclical contracts. It keeps trades neutral in a sideways moving market, and helps get in the market when a breakout occurs. A moving average of the CCI can also be displayed. A constant number is entered in the parameter screen to adjust the sensitivity of the index. This will change the visual amplitude of the index lines. FORMULAS: AVE = SUM OF LAST N PRICES / D MEAN DEVIATION = SUM OF LAST (PRICE - AVE) / D CCI = C * (PRICE - AVE) / MEAN DEVIATION CCIAVE = OLD.CCIAVE + (SF * (CCI - OLD.CCIAVE)) SF: Smoothing Factor = 2 / (N + 1) where N = periods in ave, or Smoothing Factor = 0 < SF < 1 PARAMETERS: 1st: Number of bars in the AVE average (ie. 5A). Use the H,L,M,A study modifiers. 2nd: Multiplier constant C (usually 50-150). 3rd: Optional number of bars in the CCI average (ie. 3). Example: 8,150,3 SCALE: Grid lines at the +100, 0 and -100 levels. COLOR: 1st: CCI 2nd: Exponential average of CCI HOW TO USE: Buy when CCI crosses ABOVE the +100 scale line. Sell when CCI crosses BELOW the -100 scale line. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Technical Analysis - Charting Services Last-Revised: 27 Apr 1997 Contributed-By: Joseph Shandling (jshandl at ucs.net) Thanks to the many free quote servers on the net, you don't need to subscribe to a data service or charting service just to get basic charts. The following sites offer a whole range of charts for a particular stock, as well as a lot of other information. * Yahoo! Quotes at http://quote.yahoo.com Offers 3-month, 1-year, 2-year and 5-year charts. No registration is required. Pages for a stock include links to research, SEC filings, etc, etc. * DailyStocks at http://www.dailystocks.com Offers various screens and many charts. No charge but registration is required. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Technical Analysis - Data Sources Last-Revised: 18 May 2002 Contributed-By: Zeyu Vicki Pei, Chris Lott ( contact me ) This article lists some sources of historical data. Note that currencies are traded over-the-counter, there are no central exchanges or market makers. Thus, currency closing prices are really just noisy, "best guesses" collected from a number of different exchanges and transactions. * Yahoo has a fair amount of data, both for individual issues and for indexes. http://chart.yahoo.com/d For information about what they provide, surf here: http://biz.yahoo.com/f/c.html#historical * Investors Alliance 219 Commercial Boulevard, Fort Lauderdale, FL 33308, 305-491-5100, http://www.powerinvestor.com * Micro Data Offers closing prices on stocks, futures, indexes, mutual funds, and money market funds in zipped ascii files, all for just $200 per year. http://www.micro-data.com * Bull & Bear of Italy offers historical data and end-of-date updates for markets in Great Britain, Germany, France, Italy, Switzerland, Holland, Belgium, Spain, Finland, USA, Japan, Australia, and Singapore. Annual subscription is Euro400. Please visit their site at http://www.bullbear.it/site/english * Ed Savage (contact egsavage at yahoo.com) maintains a collection of data. Stated purpose: "To collect publicly available market data in one place so people can access it easily." Donate "freely redistributable" data or access same at this URL: http://metalab.unc.edu/pub/archives/misc.invest It is NOT a real-time, 15-min delay, or close-of-day quote server. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Technical Analysis - Elliott Wave Theory Last-Revised: 12 Dec 1996 Contributed-By: (Original author unknown), Chris Lott ( contact me ) This article introduces Elliott Wave Theory. background R. N. Elliott "discovered" the wave theory in the early 1934. It is a method for explaining stock market movements. Actually, Elliott wave theory helps explain economics in general, but the stock market tends to have three attributes that make it quite applicable: 1. It is a true free market (i.e., prices are not fixed by the supplier, but rather set by the consumer). 2. It provides consistent and regular metrics that can be measured. 3. It is manipulated by a statistically significantly large group of people. Assumptions behind Elliott Wave theory * The market is NOT efficient. Rather it is an inefficient market place that is controlled by the whims of the masses. The masses consistently overreact and will make things over and under priced consistently. This was, and until recently, in direct opposition to prevailing theories that the market place was an efficient mechanism. The efficient marketplace was the theory that was taught in B-schools and often continues to be taught until this day. * That if the above is true, then you should be able to do a "sociological" survey of stock prices independent of other news that effects stock prices. ie., you will be measuring the global effects that the masses will have on the stock. (An interesting aside. We have all observed that stock prices move independently or in the opposite direction that news about the company, the economy, or the stock would tend to let us believe. The general explanation for this behavior is that the masses tend to listen for the news they are ready to hear, and that the movement that actually happens depends on other effects.) General Principle of Elliott Waves There are many things that have to be accounted for when doing e-wave studies of stocks, and that one of the most difficult things to overcome is the personal ability to separate your own emotions from affecting your analysis. You as a person have the same types of fear/greed internal mechanisms that affect the entire market place as a whole and without being able to work to dismiss those emotions you will not be able to sit in a position that allows you to understand and profit from the sociological effects that you are measuring. That basic fear/greed mechanism is so inbred to our existence that will keep the Elliott wave a valid study regardless the number of people that know and understand it. This is an important point: Elliott Theory measures sociological performance of the masses and these sociological functions are so ingrained that even if individuals or many individuals are able to understand and dismiss those actions the majority of the people will not be able to. Elliott waves describe the basic movement of stock prices. It states that in general there will be 5 waves in a given direction followed by usually what is termed and ABC correction or 5 waves in the opposite direction. Wave Description The following wave description applies to a market moving upwards. In a down market (perhaps the stock is truly overpriced and the market has turned), you will generally see the same types of behavior in reverse that you saw watching the stock on the way up. Wave 1 The stock makes its initial move upwards. This is usually caused by a relatively small number of people that all of the sudden (for a variety of reasons real or imagined) feel that the previous price of the stock was cheap and therefore worth buying, causing the price to go up. Wave 2 The stock is considered overvalued. At this point enough people who were in the original wave consider the stock overvalued and take profits. This causes the stock to go down. However in general the stock will not make it to it's previous lows before the stock is considered cheap again. Wave 3 This is usually the longest and strongest wave. More people have found out about the stock, more people want the stock and they buy it for a higher and higher price. This wave usually exceeds the tops created at the end of wave 1. Wave 4 At this point people again take profits because the stock is again considered expensive. This wave tends to be weak because their are usually more people that are still bullish on the stock and after some profit taking comes wave 5. Wave 5 This is the point that most people get on the stock, and is most driven by hysteria. People will come up with lots of reasons to buy the stock, and won't listen to reasons not to. At this point contrarians will probably notice that the stock has very little negative news and start shorting the stock. And at this point is where the stock becomes the most overpriced. At this point the stock will move into one of two patterns, either an ABC correction or starting over with wave 1. An ABC correction is when the stock will go down/up/down in preparing for another 5 way cycle up. During this time frame volatility is usually much less then the previous 5 wave cycle, and what is generally happening is the market is taking a pause while fundamentals catch up. It is interesting to note here that you can have many ABC corrections happening. For instance if the fundamentals do not catch up you will have two ABC corrections and then the stock will have a 5 wave down cycle. (Odd number of ABC corrections lead to the stock going up, even numbers lead to the stock going down.) Length and quantity of the moves People tend to think of something being too expensive or cheap for the very same reasons that they think something is attractive or not attractive. This subjective judgement is called aesthetics. A measure of what is aesthetically pleasing has to do with fibonacci sequences. They are all around us, they describe art, snail shells, galaxies, flower petals, and yes, our own internal feelings of value. The quantity of time and movement of a stock through a wave cycle tends to measured reasonably well by fibonacci sequences. The measurement and prediction of waves tends to be bound by these numbers and by the fibonacci fractions (Roughly 5/8 and 1 5/8 and their inverses) For more information, visit the Elliott Wave site: http://www.elliottwave.com/ --------------------Check http://invest-faq.com/ for updates------------------ Compilation Copyright (c) 2003 by Christopher Lott.