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I have been filing my tax returns as an active stock trader  for a couple of years.  I can tell you that there are a lot of advantages to file as an active trader than a regular investor. This post is not to teach you how but why. Once you understand why it is much better to file as an active trader, you should consult with a qualified tax preparer who has good knowledge of active trader taxes. 

As an investor, you are faced with a lot of restrictions when filing your taxes.  Here are a few serious ones

1. $3000 annual cap on losses
2. limited deductions in investment/trading related expenses
3. wash sale rules

The first one is perhaps a big headache for a lot of new traders or investors.  When one just starts out, he is bound to have a couple of losing years, which tend to be quite big.  Let’s say if you lost 30k in 2009 and you filed your taxes as an investor. You also have a regular job from which you pull in about 60k annually.  Due to the $3000 cap, you can only deduct $3000 from your 60k.  In other words, your taxable income in 2009 is 57k. I do not know why the IRS has this 3000 cap rule for the investors. But it certainly sucks for 2 reasons. First, you have only 30k in your pocket due to the loss in 2009 and yet you have to pay taxes for 57k.  Second is that it will take you 10 years to finish the  deduction if you do not recover in your losses from the market in the following years.  I am not kidding you.  More people than you think will quit after a few consecutive years of losing.

The second is that you are limited in deductions of your investment related expenses as an investor. Can you deduct the cost of all your trading equipment such as your computer, 2 24 inch LCD monitors and a Herman Miller chair?  Can you also deduct your expenses on a trading/investing monthly subscription, books, seminars, high speed Internet?  Can you claim a deduction on a portion of your home if you operate from your basement or just a room? 

The third is the wash sale rules. A lot of people perhaps already know what it is.  It is a pain in the neck.  You can not buy/short the same or similar stock within 30 days before or after you sold it for a tax loss treatment. That is a span of 60 days.  What if there is a very good set-up in that window?

As an active trader with mark to market accounting method elected, the 3 rules above do not apply to you. That is

1. There is no loss cap
2. You can claim a deduction on any expense related to trading
3. No more wash sales rules

Now you see the disadvantages of filing as an investor. But before you rush to file as an active trader, do you qualify?  The IRS has a loose set of rules for the Trader Status(business trader).  You can download the IRS publication 550 here http://www.irs.gov/pub/irs-pdf/p550.pdf .   Find the section “Special Rules for Traders in Securities”.

These were once almighty bull stocks that a lot of people salivated over.  Now look at them.  They are basically a dime a dozen.  You have no idea how many hearts they have broken.   I can tell you a lot of people are still deeply buried in these doodoo stocks. 

Some of them have already left the stock market.  But it does not matter.  New people are entering the market everyday to take up those vacancies.  Pro traders are smirking.  After all, trading is a zero sum game. 

Anyone averaged down on the following guys?

Energy Conversion Devices

DryShips

LDK Solar

 
Suntech Power Holdings

Traders are hunters. Hunting can be very exhaustive sometimes. After a few failed attempts, you are not only exhausted but hungry as well.  When you are not in your tip top shape, you tend to make more mistakes.

Let me show you one mistake I made today when I was “hungry”.  I picked my prey this morning and ambushed it. It was all good. The prey never struggled. It looked as if it was totally dead after a while. While I was preparing for the nice food, it jumped up and ran away. I was too “hungry” to remember pinning it down( moving down my stop loss).  Once it started running, I kept telling myself that it was wounded and it would fall on its own. It never happened. It just kept running and running until it totally disappeared.

That was a fat one.  If I had moved down my stop loss, I would have had 300 at least. You see I was so “hungry” that everything looked like a buffalo to me. Why? it was because I wanted one badly after being hugry for so long. It was hallucination.  A smaller one such as a deer, a goat or a gazelle would do just fine.

Anyways, I caught a gazelle in the afternoon.

Short BID [Sotheby's].  Click on the image to have a better view

I do not remember when I had a negative week last time. It was perhaps some time in early 2009. Now here it comes again. I am down more than 400 dollars last week.

Having looked at all the trades from the the last week, I found 2 issues.

1. Not a single  winner
2. Bad judgement about the general direction

Not a single winner

I normally aim for a 1.5% -2% move, which gives me 300$-400$ in profits because my position size is worth about 20k on average. Only one move was needed to cover all the losses. But I caught none. These small losers were the direct results of whipsawing.

For example, I shorted CF(CF Industries Holdings) and CLF(Cliffs Natural Resources ) on last Friday.   They never really moved in my direction that much.  I could have had a small profit in my CF short(200 dollars). But it was not my plan.  My thinking was “OK move 1% more, I would break even this week”. It was a wishful thinking and that position ended up flat.

Click on the image to have a better view

Bad judgement about the general direction.

We had a nice rally last week.  But 50% of my positions were on the short(wrong) side. Trading against the general trend is like an uphill battle, which is totally opposite of choosing the path of least resistance.

There is at least one shinning spot in my trading last week. That is my risk control. A loss of 400$ in a week is perhaps nothing because I only need one winner to cover that.

By the way, although there is 150k sitting in my account, I rarely use more than 50k at one time. But knowing that I have enough capital to cover the rainy days(a long losing streak) makes me sleep better.