It was Benjamin Franklin who famously said that “in this world nothing is certain but death and taxes.” Should anyone be successful at trading or investing and generate profits rather than losses in this activity, sooner or later he or she should expect Uncle Sam to come calling to claim his cut. This is true even of income generated in a traditional tax-deferred IRA, as opposed to the Roth version mentioned above. Of course, nobody likes to pay taxes. Equally, however, when we go out to work to a paying job, as most of us do, we accept the inevitability that a significant portion of our earnings will be siphoned off by the tax man. Strangely, while we accept that the income earned from our jobs will be taxed, many of us are fixated on tax-avoidance in our investing habits. We are also encouraged in this by financial advisors. This tax phobia has such a hold on some people that it reaches the point where they will even accept lower returns on their investments as being more desirable so long as they come tax-free.
Do not misunderstand us on this point—there can be very good reasons to choose an investment path that enables you to reduce or even eliminate a tax burden. For example, the tax deduction on mortgage interest is one of the economic underpinnings of making home ownership such an attractive investment in the United States. But should you decide to go down the road of generating an extra income from stock market trading, then paying taxes on that income, whether as part of your annual tax filing or on a tax-deferred basis once an IRA is cashed out, has to be understood as being part of the territory. In order to demonstrate the absurdity of people’s tax phobia on investments, ask yourself this—how many people decide that they will no longer go out to a paying job any more because they have to pay tax on the income they earn there?
Coauthor Martha Bro˙zyna’s father has an expression he often uses in this context, “I want to pay a million dollars in taxes.” When the person he says this to looks at him as if he has just sprouted a second head, he explains, “if I pay a million dollars in taxes, then just imagine how much income I’ve made.” The kind of person who can take advantage of the ability to trade for an extra income is the kind of person who will not be upset that his taxes have gone up from one year to the next. He will understand that this rise in taxes is simply a reflection of the increase in his overall income for the year generated by profits on his trading. This is even true taking into consideration the higher capital gains tax payable on short-term gains as opposed to those made on positions held over 18 months. Again, just as you would not turn down a promotion at work because the higher salary would mean paying more in tax, the differing levels of taxation applied to long-term and short-term trading gains should not dissuade you from trading if this seems the more lucrative path overall for you.
Along with vilifying the payment of taxes, many investment writers point out, quite rightly, that the more trading a person does, the more he will have to pay in commissions to his broker. Until relatively recently, commission costs generated by trading would have been a huge impediment to a trading strategy involving the making of a significant number of roundtrip trades in stocks. However, for traders who are seeking online execution only, the cost of trading these days is relatively small. At the time of writing this book, we pay just $5 per trade with our principal online brokerage E*TRADE (with rates set this low as we are legacy Brown & Co. clients, with $5 commission rates grandfathered from our former brokerage house which was acquired by E*Trade in 2006); $7 per trade with Scottrade, and $9.95 per trade with Charles Schwab. Nevertheless, many authors of books that rail against trading argue that commissions eat away at all or most of the trader’s profit. This is because active traders can do dozens of trades a day, so commission costs can really add up. It is certainly true this could be particularly onerous to a trader if some of his trades are loss-making. After all, the trader has to pay commissions regardless of whether he makes a profit or loss from his trade. This circumstance does not affect our method, however. We always factor in the costs of commission for doing a roundtrip trade when calculating the price at which we intend to sell our stock. More
importantly, we do not sell at a loss, preferring instead to wait, maybe even for months until the stock goes back up. (See more on selling with our method in Chapter 4 and check out Appendixes A through C for the full record of our profitable closing sales.)
A third transaction cost that investment writers, correctly, point to is the spread between the bid and ask price—the trader buys at the ask price and sells at the slightly lower bid price and this difference constitutes a real cost. The cost of the bid/ask price spread is really only an issue, however, if the stock being bought and sold is small and thinly traded. This is especially true of a NASDAQ quoted stock, although even there spreads have been forced to come down in the last years. The bid/ask spread that is usually found with the well-established large-capitalization stocks that are traded mostly on the New York Stock Exchange is typically just one or two pennies a share, and as such represents a very small “cost of doing business.”
Moreover, the spread between the bid and ask price has been reduced in recent years because of changes made in the way stock prices are quoted. For most of the stock market’s history, pricing was done through whole dollar amounts and fractions (half, quarter, one-eighth). This system was based on the Spanish real which was divided into eighths. Between 2000 and 2001, U.S. stock markets converted all their stock prices from fractions to decimals. As a result, whereas the lowest typical spread in the old system using fractions had been 1/16th or 6.25 cents, now the use of decimals allowed for narrower spreads, a development, which was further encouraged both by competition between market makers (and Internetbased market places known as electronic communication networks or ECNs) as well as regulatory pressures.
The three types of costs just examined are used by investment writers in their warnings against “churning” or what they perceive as excessive trading. While we agree wholeheartedly that nobody likes to pay taxes, commissions, or bear the additional small expense of the spread between bid and ask prices, we feel that the approach of certain investment writers to these costs is still one that is somewhat biased owing to a general preference for buy and hold strategies. We like to think of the gaining of an extra income through short-term trading in the same way as taking on an additional paying job. Just as taxation, expenses, cost of commuting, and, perhaps, purchase of professional clothes such as business suits would not turn most away from a job that provides real returns in the form of a good income—so the costs that go along with active short-term stock trading can be seen in the same light.
It is now time for us to turn our attention to the short-term trading technique that it is this book’s mission to espouse. Let us now introduce some of the foundations on which we have built our contrarian ripple trading method. We start with an explanation of the term we have chosen for our short-term trading strategy, “ripple trading,” and for this we turn briefly to an examination of Dow Theory.
Read More : THE COST OF TRADING: IT’S NOT AS BAD AS THEY MAKE IT SOUND
