The Ugly Downside of Successful Trading

Things looked great on paper in 2013. Then 2014 brought a cold dose of reality.

Feb 12, 2014 at 9:00AM

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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Chuck Saletta has open options positions on American International Group, Atlas Air Worldwide Holdings, and Sanmina-SCI. The Motley Fool recommends American International Group.The Motley Fool owns shares of American International Group and has the following options: long January 2016 $30 calls on American International Group.

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