Wash Trading
The deceptive practice wherein a broker or dealer executes buy and sell orders for the same stock to create false trading activity
What Is Wash Trading?
Wash trading in finance refers to the deceptive practice wherein a broker or dealer executes buy and sell orders for the same stock to create false trading activity.
In simpler terms, it involves two or more brokers trading amongst themselves without genuine transactions. Brokers can also do this professionally to deceive investors into thinking that trades are being made by professionals when no goods have been exchanged.
Wash trading involves the deceptive practice of buying and selling an asset without genuine ownership, often to manipulate market activity.
Those engaged in wash trading typically hold an asset for a prolonged period, artificially inflate its value through trades, and then sell it at a higher price to exploit the market manipulation.
Key Takeaways
- Wash trading involves deceptive practices in finance where brokers or dealers execute buy and sell orders for the same stock to create false trading activity, often to manipulate market activity.
- Wash trades require intent and result in buying and selling the same asset without genuine ownership, usually within a short timeframe.
- Wash trading is illegal under the Commodity Exchange Act and regulations enforced by the Commodity Futures Trade Commission (CFTC). It is also subject to strict regulations by the Internal Revenue Service (IRS) concerning tax deductions for capital losses.
- Investors can avoid wash trading by documenting all trades, understanding wash sale rules, and complying with tax regulations.
Understanding Wash Trading
Wash trades involve deceptive transactions where an individual or entity simultaneously buys and sells the same security, often involving collusion between investors or coordinated actions with a broker.
An investor issues a buy order and a sell order for securities in order to complete a wash transaction.
This action resembles insider trading as it involves manipulating the market by creating false activity, but it's not precisely insider trading, which involves trading based on non-public material information.
Insider trading broadly includes trading activities based on material non-public information that could impact a security's price.
The investor engages in this deceptive practice leveraging their knowledge of market dynamics, but it doesn't necessarily indicate expertise in trading.
How Does Wash Trading Work?
Typically, two conditions must be met to identify a wash trade:
- Intent: The involved parties, whether the broker or investor, must demonstrate intent, indicating that at least one party entered the transaction with the specific purpose of executing a wash trade
- Result: The outcome of the transaction should constitute a wash trade, where the same asset is bought and sold simultaneously or within a short timeframe for accounts sharing common beneficial ownership
Common beneficial ownership refers to accounts owned by the same individual or entity. Transactions between such accounts may attract regulatory scrutiny as potential indicators of wash trading.
A key marker of wash trading activity lies in the level of risk assumed by the investor. If a trade fails to alter the investor's overall market position in the security or expose them to market risk, it may qualify as a wash trade.
Note
It's important to note that wash trades can occur even without actual transactions. They may manifest when investors and traders simulate trades on paper without any asset exchange taking place.
What is the Wash-Sale rule?
The wash sale rule is a tax regulation that prohibits investors from claiming a capital loss on a security sold in a wash sale, which occurs when a substantially identical security is repurchased within 30 days before or after the sale.
The reason why it's recommended to know this rule, in general, is because it can impact your overall financial position and whether or not you owe taxes on the gains and losses incurred by your stock holdings.
The wash sale rule prohibits claiming a capital loss on shares if substantially identical securities are acquired within 30 days before or after the sale.
There are two other definitions of 'wash sale' as well:
- A wash sale occurs if you buy a stock you already own and sell it within 30 days of buying another share in the same company
- It also happens when you make a short sale to offset an existing long stock position and buy the same stock within 30 days
Why Wash-Sale Rule?
What do I know if you apply the wash-sale rule correctly? First, you can avoid wash trade and pay tax on your capital gains generated from stocks that provided higher returns over time.
Note
If you're lucky enough to have made some profits and don't need a tax deduction to reduce your taxable income, then simply move them forward in the account.
Over the past decade, one of the leading performers in the US stock market has been looked at as a primary example of a wash sale event due to his consistency in buying shares of the same company and selling at lower prices.
Stock trades occur when buyers and sellers agree on a price for a specific security, whether through direct negotiation or via market orders. This reveals the risk involved in stock trading; you must know the stocks you want to buy and the stocks you want to sell for the transaction to go through.
Example Of A Wash Trade
Wash trading is a form of market manipulation where an investor simultaneously buys and sells the same financial instrument to create artificial trading activity and inflate volume. Here are some examples of wash trading:
- An investor buys 100 shares of a stock at $10 per share and then immediately sells 100 shares of the same stock at $10.10 per share, creating the appearance of activity without any actual change in ownership
- A trader places buy and sell orders for the same quantity of a cryptocurrency at slightly different prices on different exchanges to manipulate the market and mislead other investors about the true demand for the asset
- A trader repeatedly buys and sells a futures contract to themselves at the same price, without any change in market position, to create the illusion of trading activity and artificially boost volume
- An investor places buy and sell orders through multiple accounts they control, effectively trading with themselves to manipulate prices and deceive other market participants
- A brokerage firm engages in wash trading on behalf of a client to meet volume requirements or trigger specific trading algorithms, without any genuine market interest or intent to profit
Is Wash Trading Illegal?
Indeed, wash trading is illegal. The Commodity Exchange Act expressly forbids wash trading, aiming to curb market manipulation and price distortion practices prevalent among traders before the Act's enactment.
The Internal Revenue Service (IRS) also has stringent regulations concerning wash trades. These rules prevent investors from deducting capital losses on their taxes arising from the sale or trade of stocks or other securities involved in a wash sale.
According to IRS guidelines, a wash sale occurs when stocks are sold at a loss, and within a 30-day window before or after the sale, you:
- Purchase substantially identical stocks or securities
- Engage in a fully taxable trade involving substantially identical stocks or securities
- Obtain a contract or option to buy substantially identical stocks or securities
- Purchase substantially identical stocks for your individual retirement arrangement (IRA) or Roth IRA
Wash sale rules extend to instances where stocks are sold by one party while substantially identical stocks are acquired by their spouse or a corporation under their control. Once a wash sale occurs, any tax deduction for the losses incurred is invalidated.
Note
The Commodity Futures Trade Commission (CFTC) further reinforces this prohibition by enforcing regulations that prohibit brokers from benefiting from wash trade activities.
How To Detect And Avoid Wash Trading
If you find yourself in a wash-sale scenario, tax regulations require you to wait at least 30 days before repurchasing the same investment to avoid the wash sale rule.
Given this time frame, it's important to document all your trades and familiarize yourself with what qualifies as a wash sale. The IRS also has some strategies for helping you identify whether or not your trade will result in a wash sale.
Reporting a wash sale involves specific requirements and considerations.
It's like a negative option. If you don't report a wash sale by the deadline, then one year after the transaction, you are deemed to have sold that asset at its fair market value (FMV) on the last day of the year.
Failure to report a wash sale or file the correct form by the deadline can lead to adverse tax consequences, potentially affecting your tax liability.
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