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17

The Ugly Downside of Successful Trading

In May 2012, I embarked on an experiment to search for Warren Buffett's secret to 50% annual investing returns. In 2013, that experiment exceeded my wildest expectations -- on paper and before taxes, at least -- with a gross return for the year in the neighborhood of 100%. Yes, with that strategy, it appeared as though I had essentially doubled my invested money in the space of a year.

And then the calendar flipped over to 2014, and with that simple change in perspective what looked on paper to be wildly successful turned out in practice to be substantially weaker. The difference in early 2014? The realities of taxes, volatility, and the pain of margin struck hard and fast.

The tax man cometh
The strategy I've been experimenting with centers around short-selling options to capture decaying time value. When it works -- which it did phenomenally well in 2013 -- it generates a lot of trading activity. According to my TurboTax records, I completed 143 trades in 2013 on that strategy, each of which has to be accurately accounted for to the IRS and statehouse for taxes.

In addition, because the strategy centered on short-selling options and short-time-frame transactions, most of those transactions count as short-term capital-gains taxes. Since short-term capital gains are taxed at an investor's marginal income-tax rate, they can get pretty expensive, pretty quickly. On top of the direct taxes, adding those gains to our gross income drove some phase outs of some tax credits, making the net tax rate higher.

Between state taxes, federal taxes, and federal credit phaseouts, my best estimate is that about 40% of the gains I realized in 2013 from those trades will wind up in the hands of the tax man in 2014. Not only that, but to protect myself from being socked with penalties in 2015 for underpaying my 2014 taxes, I've had to increase my paycheck withholdings by an equivalent amount.

Or in other words, about 80% of those supposed 2013 realized gains will find their way to the federal and state tax coffers in 2014. That said, we may get some of it back in 2015 depending on how the rest of 2014 winds up, but it's still cash out of my family's pocket for most of this year.

Volatility and uncertainty are back
The overall market dropped roughly 3.6% in January 2014. Add the natural leverage of options to the unnatural leverage that comes from leaning on margin, and this account fell even further, dropping about 4.7% in total. That's even after accounting for the benefit from the time decay still being captured by the successful part of the strategy.

Airplane leasing company Atlas Air Worldwide (NASDAQ: AAWW  ) has been my biggest disappointment in early 2014, driven by news that three leased planes would be returned to one of its subsidiaries. While Atlas Air looked like a decent fit for the strategy when I set up the initial position, that surprise return added a business wrinkle I hadn't accounted for.

Still, as with any investing strategy, the uncertainty of business outcomes is a risk to an investor. It's when you add leverage to that risk that the pain goes from manageable to immense.

Throw in a margin call (or three)...
In part because of Atlas Air Worldwide's negative surprise, and in part because of the general market sell-off in January, the account where I execute this strategy got hit with a series of margin calls. With all our available cash (and then some) needed to cover those 2013 taxes due in 2014, the best available source of money to satisfy those margin calls came from that account itself.

To add insult to margin-call injury, the most effective way to satisfy those margin calls was to buy back short put options that had lost virtually all their time value. While the put options I bought back on electronics manufacturer Sanmina (NASDAQ: SANM  ) would have expired in 2014, the ones I bought back on insurance giant AIG (NYSE: AIG  ) could otherwise have waited until 2015. The AIG transaction created additional taxable income in 2014, while the Sanmina transaction added churn and commission costs to an already churn-filled account.

As economist John Maynard Keynes said, "Markets can remain irrational a lot longer than you and I can remain solvent." That's especially true when margin calls are involved. If you're an investor leaning on margin, you've got to be able to meet a margin call on time, or your broker will start liquidating your positions to cover that call. And while you can often pick and choose how to meet a margin call when it's still in your control, if you don't meet it on your own, your broker might not look after your best interests when liquidating positions for you.

It all nets out to one big mess
The still unanswered key question is whether my experiment's 2013 paper success was anything more than a leveraged net long position combined with a rapidly rising market. Frankly, I believe sheer dumb luck had a lot to do with it. That's especially true now that 2014 has brought with it the tax bill for that success, the return of volatility and uncertainty, and the pain of margin calls.

Luck or not, I intend to keep at this experimental strategy at least a little while longer. If nothing else, trying to manage through what looks like increased volatility and a less directly upward market trajectory in 2014 will help me see how much of that 2013 success was really due to luck. If what has happened so far in early 2014 is any indication of things to come, it won't take too much longer to realize that Keynes was right -- and even if my experiment could work over time, the market will find a way to derail it completely.

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Read/Post Comments (17) | Recommend This Article (17)

Comments from our Foolish Readers

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  • Report this Comment On February 12, 2014, at 6:36 PM, LeeG3 wrote:

    Just a single question - isn't the Fool's mantra to buy and hold long-term great companies and to not try to beat the "market"?

    Maybe this is an article to support the mantra by showing what happens if you try to time the market.

  • Report this Comment On February 12, 2014, at 6:39 PM, FundamentalsMan wrote:

    I understand the importance of the difference between short and long term gains, but this seems exaggerated. The 80% statement also seems a bit disingenuous as you are effectively counting the 40% twice to arrive at that figure. I'd love to see what the impact would have been had you realized long term gains instead of short term.

  • Report this Comment On February 12, 2014, at 7:46 PM, gr8twhtebuffalo wrote:

    To a new investor this article is confusing and scary. For now I'll buy and hold and learn about shorting and puts along the way :).

    Thanks for the read.

  • Report this Comment On February 12, 2014, at 7:51 PM, cmalek wrote:

    You are looking at the glass as being half empty. Yes, it is galling to pay the Taxman so much but look on the bright side - you have 20% more in 2014 than you had in 2013, and judging by the tenor of your article, that ain't no chicken feed.

  • Report this Comment On February 12, 2014, at 7:54 PM, cmalek wrote:

    @greenbear28:

    The one problem with buy and hold is that, since you never sell, the gains are only on paper.

  • Report this Comment On February 12, 2014, at 8:53 PM, TMFBigFrog wrote:

    Hi Fools:

    Forgive me for being somewhat vague with numbers in the article. That was intentional, as there's only so much of our personal financial information that I'm willing to share online...

    To address the point that 40% * 2 isn't really a fair number for the tax cost in 2014 -- that may be technically accurate, but it doesn't change the out-of-pocket tax-related costs I'll be facing in 2014. Had I had perfect foresight, I could have withheld for 2013 taxes in 2013. Instead, I withheld in 2013 based on 'safe harbor' provisions that kept me from getting hit with a penalty. As a result, I owe money in 2014 for my taxes on income earned in 2013. But, to be protected by the same safe harbor for 2014, I have to increase my withholdings during 2014, as well -- hence the out-of-pocket perspective of a larger bite. I'll know in 2015 how much (if any) of that additional withholding might get returned, but for 2014, it's money out of pocket to the tax man.

    In terms of the benefits of traditional buy-to-hold investing vs. this particular strategy, a key difference is that in this strategy, I'm relying on "time value decay", which is generally greatest in the last 1-3 months of an option's life. That forces trades -- and taxes -- which tend to be short term in nature. In a buy-to-hold strategy, taxes are generally only due on dividends (maybe) or when an investor eventually sells a position at a profit. And if a gain is long term, it's typically tax advantaged vs. short term gains. So with a buy-to-hold strategy, there's rarely a compelling need to close a position (and expose the gains to tax), and the long term gains that do result are usually taxed at a lower rate.

    Regards,

    -Chuck

    Inside Value Home Fool

  • Report this Comment On February 13, 2014, at 10:14 AM, Mega wrote:

    If your portfolio can't handle a 4.7% decline without a margin call, it's clear you are using dangerously high leverage.

    10%, 20%, 30% declines are normal in the stock market.

    How would your strategy have performed in 2008 or 1987?

  • Report this Comment On February 13, 2014, at 2:45 PM, TMFBigFrog wrote:

    Hi Mega --

    Fair enough -- and in truth, that's one reason why I'm viewing this as an experiment, rather than a settled strategy.

    Regards,

    -Chuck

    Inside Value Home Fool

  • Report this Comment On February 14, 2014, at 10:24 AM, ScoopHoop wrote:

    Interesting reading. Lessons to be learned here. I experimented with "day-trading" in the early 2000s and made no money. I returned to deep-dish value investing and have been rewarded handsomely, especially for the trades made in 2009 and 2010 and 2011. I might do 10-15 trades per year, mostly buys, that's it. Like most investors, I had a good year in 2013, actually my best year ever, but I will have to pay taxes on my dividends and capital gains. My 32% return in my brokerage account in 2013 will probably be more in the line of 27% after taxes. Buffett once said he would not borrow money to buy stocks. What if your trade goes south? I just bought SJM at 93 and now have a small loss in it, but I can hold this stock forever because I owe nothing on margin, the stock will rebound eventually. A margin call forces the trader to make a decision now: sell for a loss and pay the piper or cough up new cash to pay the loan. I am looking for a margin of safety and minimal risk in every trade. I bet big on HSY and UNP and now my accounts are up YTD, albeit only 30 basis points, but I will take it. I expect the stock market to be in bearish territory for most of 2014, or swing sideways. This means investors better make sure they are in the right stocks or they are going to have a poor year.

  • Report this Comment On February 14, 2014, at 11:34 AM, TerpFan90 wrote:

    Good article Chuck. I executed a similar strategy in 2013 accomplishing a 127% gain. About half the gain I can attribute to the options strategy, the other half to my buy and hold positions-- most are Stock Advisor picks (Thanks MF!)

    For a margin of safety, I tried to keep at least 20% of the portfolios value in available margin to avoid the margin calls. Also, I used a combination of long term options (a year or more) and some shorter term options (one to six months). I did about 80 trades.

    I haven't done my taxes yet, so we will see if I can keep the 2013 return above the century mark. But even if it dips significantly, I am a glass half full kind of guy and I will gladly pay the taxes if this strategy continues to deliver market thumping returns.

  • Report this Comment On February 14, 2014, at 12:34 PM, mcampbell8 wrote:

    Call me simply, but I avoid options and margin calls. While the upside can potentially be significant. Many have been completely wiped out by this approach. Too risky for me, especially in a fluid market. I will stick with the slow and steady gains of value investing and buying and holding quality companies.

    Chuck - Are there any other tax strategies to minimize the tax burden?

  • Report this Comment On February 14, 2014, at 1:16 PM, Haggy wrote:

    "isn't the Fool's mantra to buy and hold long-term great companies and to not try to beat the "market"?"

    No the goal is to beat the market, and in my case, my goal is to trounce the market. In general, the Fool is about buy and hold. But TMF Options is about using options in conjunction with investing, not as an alternative.

    I don't like taxes and for years did everything I could to stick with "buy and Hold" and avoid taxes as much as possible. But using options in conjunction with that might give me extra taxes, but might also give me income on top of everything else without taking away from my existing portfolio.

    To give an example, I have one stock that I've had for over a decade in a boring nuts and bolts company. Its growth and expansion has been fairly predicable. But in the short term its price has been going nowhere but volatile within a range. Adding a strangle gives me immediate income at both ends. I can do it three months out and repeat it every three months for more income. It won't affect the amount I have invested. The worst case scenario is that it drops too low and I end up having to buy more shares at a bargain price. But if you factor in the income I got from the strangle, it really cost me effectively much less than that price, is for a company that I own anyway and would be glad to buy more at a low price.

    I could, in theory, end up paying more than the selling price due to the written put. But with the price currently around 45, the strangle from 40 to 50, and with a dip below 40, I'd end up paying effectively 38.25 when you factor in the income from writing the strangle. So I'd be getting the stock at a whopping discount and would NOT sell it upon expiration. I'd have more shares of a company I own anyway but at a big discount.

    On the other hand if it goes above 50, I'll end up selling my shares for 50 whether I want to or not. But I'd gladly accept 50 and if it went up after I sold it, I wouldn't care, so if I sell it at 50 when it's at 60 (not likely) then it would be no worse than if I had sold it at 50 and it went to 60 later. But selling it at 50 would really be like getting 51.75 when you factor in the income from the strangle.

    So in this example if it hit that price a month from now, I'd have made about 15% in one month. Not bad. I'd accept that. The sale of the stock would result in a capital gain. Without the strangle I would have seen a 10% jump in a month and paid long term gains on it. With the strangle, I got extra income for doing nothing, and if I pay taxes on it, it's not as if it's money I could have invested elsewhere. It's money I didn't have until I wrote the strangle and money I never have to give back. So that amount minus taxes is still a gain of that amount compared to no gain.

    In all likelihood the price will stay under 50 and the income from the strangle will be pure profit. But the worst case scenarios are both better than if I had decided to buy more at 40 anyway and sell at 50 anyway, and later watch the price go up after I sold it or down after I bought it.

    Looking at long term vs short term is important. But it's like comparing highway mileage to local mileage on your car and complaining about gas mileage. If I took my car and drove it an extra few hundred miles each week on the highway, my average MPG would be higher but only because I wasted gallons of gas for no reason. If I didn't add the options, then taxes would be lower, but it would be because I got neither the extra income nor paid the taxes on it.

    If you had a choice between earning $100,000 per year and paying 10% in taxes or earning $300,000/year for the same work and paying 50% in taxes, which would you pick? Those are extreme examples, but it's the bottom line that counts.

  • Report this Comment On February 14, 2014, at 2:40 PM, erich69 wrote:

    Buffett may have said he wouldn't borrow to invest in stocks but that is misleading....he was referring to investing with margin which is risky and expensive, but Buffett was able to make a fortune by essentially borrowing to invest...he used his insurance company as the vehicle to take advantage of the float. There are relatively few companies that can be bought and held very long term as economics and competition are always changing. If you look at Buffett's track record he often held a security for about 4 years on average...only a few like coke, p&g, geico, etc. have business attributes that make them very long buy and holds. I like the buy and hold strategy, but if you buy and hold for only a couple years until the market gives you a ridiculous overvaluation then go ahead and sell and buy back in the future at a lower price when investors become reasonable again. Think about this...if you owned a pizza joint that was doing great business and someone offered you an absurdly large amount of money to buy it...aka think of the p/e ratio with stocks for valuation...so much so that it would take 50 years before they would have made enough in profits to break even from the ridiculous amount of money they gave you to buy the business...hope this puts things in perspective. It should be a joy to pay the tax man because it means you made a great profit!

  • Report this Comment On February 14, 2014, at 4:40 PM, WHOVPLLC wrote:

    TMF is very, very interesting. -- After years or perhaps well over a decade of avocation for the generally false idea that members of the Motley Fool can 1. Outperform the Market, 2. Outperform the Mutual Funds, the Motley Fool offers fee based Premium investment newsletters, and fee-based Mutual Funds marketed primarily, if not exclusively to members of Fool.com.

    Since 2012, I have primarily invested in small, private carefully selected start-up and early stage companies in several select industries where the Partnership has special expertise and a competitive advantage.

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    Founding General

    Partner 2012

  • Report this Comment On February 15, 2014, at 5:31 AM, ellaerdos wrote:

    Good piece, provokes a lot of thought.

    I do some of what Mr Graham called "Cigar Butt Investing", except I don't use calls or puts. Not borrowing money keeps expenses down and the time line workable to market conditions.

    I have done well over the years, have had some losses, and been clipped by huge tax bills. I too estimate that with the tax bill, a profitable short term trade will cost me 40 cents on the dollar.

    Being retired and living on a pension and SSI does not save you from the Adjusted Gross Income Tax calculation.

    That said, active trading beats buy,hold and forget any day.

  • Report this Comment On February 15, 2014, at 6:05 AM, ellaerdos wrote:

    One more comment from an old guy. Someone asked if their was anything they could do about this problem - their is, keep it from getting out of hand! 1.) Have your taxes done by a CPA who has been through an IRS audit. 2.) Take all the legitimate deductions you are entitled to, but be careful 3.) If you make a really big short-term killing during the year make a voluntary tax payment of at least 25%, 4.) Don't do any funny crap, you know, off shore banks, oil tankers, phony businesses etc. 5.) File, even if you can't pay.

    Enjoy the ride!

  • Report this Comment On May 08, 2014, at 1:37 PM, thidmark wrote:

    "That said, active trading beats buy,hold and forget any day."

    Yes, if you're a brokerage ...

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Chuck Saletta
TMFBigFrog

Chuck Saletta has been a regular Fool contributor since 2004. His investing style has been inspired by Benjamin Graham's Value Investing strategy, and he manages the real-money Inflation-Protected Income Growth portfolio on Fool.com based on many of Graham's principles. Chuck also can be found on the "Inside Value" discussion boards as a Home Fool.

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