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This Week's Guidepost

“THE TAX MAN COMETH - 3”

1. Last week we extended our understanding of the portfolio planner to include the tax ramifications, illustrating the size of the bite the IRS will take out of our increase. Our portfolio return in the example shown reduced a 48% return to under 28%. This was just one fictitious example but served as a wakeup call for the novice who has yet to file their first return with investment capital gains. There are different tax provisions that apply to an “investor” as opposed to a “trader.” We will address that difference in this guidepost.

2. There are over five million on-line traders working the web today with the number growing rapidly. Each participant must meet the Tax-Man in April and as the tax forms are filled out, each one of us must file as an investor or a trader. Trader status is more complex but provides a few benefits worth considering. It is also more difficult to qualify as a trader. The IRS conveniently does not define the difference, leaving the distinction to the tax courts. We have a number of court decisions to help us decide if the trading activity is a bona fide trade (business) or if it constitutes a hobby. The courts have made it clear that a high-volume short-term trader should receive different tax treatment than one who occasionally engages in a short-term trade. Here are some criteria:
   The Investor: A taxpayer whose investment activity is usually not his sole source, or even his main source, of income.
   The Trader: A taxpayer involved in the activity with continuity and regularity whose primary purpose in engaging in the activity must be for income or profit.
   The Investor: A taxpayer who buys and sells securities with the idea of realizing income in the form of interest, dividends and hopefully, capital gains from an appreciation in value over some period of time.
   The Trader: A taxpayer who engages in a trade or business involving active sales or exchanges of securities on the market, rather than to customers.

3. If there seems to be some level of overlap between these examples, welcome to the IRS. Before we get too far into an investing activity it would be wise to seek advice from a professional accountant or CPA firm. This bit of preventive medicine will provide rich returns in the long run. One generic rule applies to both. Any commissions paid to your broker are used to reduce capital gain or to increase capital loss when you sell. In either case, gains derived from investing or trading are subject to the income tax but not to self-employment taxes.

4. In light of the increased tax burden we have just considered, an obvious question is whether all this effort is worth it. Are we really making any money? To help answer that question and provide a short review of the success of our web site we went back to the picks made just one year ago, 3/19/99. Had we invested in any of those picks at that time, how did we fare? The table below lists the 10 picks that week with the purchase price (entry) and the closing price on 3/17/00, one year later. The % Return column lists the percentage gain for the price between these two dates. This is pure math, without commissions or trading slips. Notice the first two tickers, AATT and DLGC, were not traded through the entire year, but were discontinued as they were acquired by larger companies on the dates shown.
   
   

5. These percentages would have been the result of a strict buy-and-hold methodology. The fact that 7 of the 10 had positive returns demonstrates the value of having picks with strong fundamentals. The third column in the table lists the highest price each ticker reached during the year with the last column showing the resulting returns. What this demonstrates is the fact that we didn’t buy these stocks to hold, but to roll for higher returns. Using simply the one roll with the highest price increases the average return by 80%. Obviously, we won’t get these returns when we actually buy and sell somewhat below the highs and above the lows. We miss the action and benefit of the rolling strategies without looking at the chart. Let’s take one of the tickers, ETEK, to see more closely what is possible. This is an unusual stock, clearly NOT representative of the average, but will serve to illustrate the METHODS we advocate for higher than average returns.
   
   

6. We offered this stock on March 19, 1999, where the gray line is positioned. The stock took quite a run up and we should have been happy to sit on the sidelines and enjoy. However, this pattern demonstrates one of the very attractive features of volatility, accompanying the upward trend. This is called a “Range Rider.” To take advantage of the pattern, we buy in the trough, sell on the crests. Of course we can’t buy at the lowest point or sell at the highest point. How close we come to that is a measure of our ability to read the charts and to pull the trigger when we get the signals. In any case, the table below shows the ideal buy and sell points during this years period and the resulting trading performance assuming we only get 60% of the possible increases on each roll.
   
   

7. For instance, had we invested $1,000 on 3/19/99 and sold on 4/4/99 with a $20 commission for both the buy and the sell, we would have pocketed $1,256. Now this calculation assumes we only realized 60% of the price increase on this roll. The rest of the table repeats the process, investing all of the money in the last column on each next trade, thus compounding the return on our investment. For the entire table, we executed 10 buys and sells, costing us a total of $400 in commissions. We still walked away with $15,604, or $14,604 more than we started with! Had we caught 80% of the increase of each roll, the take-home would have been $35,257. On the other end, even with only 40% of the increase included, we would still have marched home with $6,270.

8. I don’t know how close any of you can come to the ideal return. But if you can’t beat 40% you should be whipped with a wet noodle. In any event, the activity can overcome the negative influence of the IRS.

9. I repeat: We are not tax specialist nor tax advisors. You are advised to seek the help of a tax specialist on these issues as they impact your trading success. The PIP (Personal Investment Planner, shown below) is only for planning purposes and serves that role well. In fact, if you are interested in obtaining a copy of the PIP software (Excel spreadsheet format), it could be available on the order page for cost, one disk, S&H for $5.00, if requested.
   Enter data in green shaded areas, the balance will be automatically calculated.

   Recently (12/28/99), eminent stock market chartist and guru Don Worden (founder of TC2000) made the following comment: “Every stock has a personality. You should study a stock's personality before you attempt to come to conclusions about its technical strength or weakness... “

   To Worden’s observation we add a hearty hurrah! That is the purpose of the Rolling Analysis section. It is not to fix buy and sell triggers. It is to help us understand the personality of tickers we are considering to be rollers. This is but one unique and proprietary feature of Pro-fundity that sets it apart from other rolling stock web sites. Properly utilized, this will provide a market sense and understanding of the nature of what we call “rolling stocks,” increasing their successful use to fatten our wallets.

It is our intent to help our subscribers understand market strategies well enough to make informed decisions and understand the risks.

TC-2000 tutorials are available on the home page.

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