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A wash trade is an illegal practice traders may use to manipulate the market. Wash trading gives the appearance that a stock or security is more popular than it really is. Traders may also make a wash trade to lower their tax liability. To stay out of trouble, here’s what wash trading is and how to structure trade activity to avoid wash trades.
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How Does Wash Trading Work?
Wash trading occurs when a purchase and sale of securities match each other in price, volume and time without a change in ownership, according to the U.S. Securities and Exchange Commission (SEC). Some traders conduct wash trades to manipulate the market. Traders who buy and sell the same securities within a short period may do so to bolster their trading volume. Artificially boosting a security’s buy and sell activity can drive up its price and inspire legitimate traders to invest.
Wash traders may also attempt to claim a tax deduction. A wash sale happens when a trader sells a security at a loss and then buys the same amount of the security back a brief time later. Even though the trader owns the shares, they might try to claim a tax deduction for their initial loss. However, the wash-sale rule does not allow an investment sold at a loss to be claimed if it’s bought back again within 30 days.
Wash trading takes into account the intent of the trader and the actual result. If the intent of the trade was for market manipulation and occurred without a change of ownership, then it was a wash trade.
Wash Trading Example
Wash trades may happen when traders and brokers artificially generate stock activity to attract other investors. Assume ABC trader and their broker want to bump up the price of a security. ABC trader buys and sells shares rapidly. The increased activity pushes the stock price upward, which attracts legitimate traders to buy the securities. ABC trader then shorts the stock by selling it at the inflated price and repurchases the security at a lower price shortly after that.
A wash trade also occurs when investors seek to take advantage of tax deductions. Assume an investor holds 10,000 shares of XYZ stock. On December 1, the investor sold all 10,000 shares at a loss of $2,000. The next day, the investor buys back the same number of shares of XYZ stock. Despite keeping their entire investment, the trader tries to claim a tax deduction of $2,000 for the initial loss. This is in violation of the wash-sale rule. The stock has also not changed ownership by the end of the wash trade.
The Legality of Wash Trading
Wash trading is an illegal practice under the Commodity Exchange Act of 1936. Under the Act, fictitious transactions or those that cause the price to be untrue are prohibited. A wash trade may occur in any industry and with any asset sold on a market or exchange.
A wash trade may happen when traders and brokerage firms buy and sell the same security briefly, intending to inflate trading volume or artificially raise the price. Traders who sell a security at a loss and then repurchase and sell the security at a gain may also commit a wash trade if their plan is solely to take advantage of a tax deduction.
Common Places Wash Trading Occurs
Wash trade rules apply to assets classified as securities, such as stocks, bonds and other financial instruments. However, new ways of trading securities and investments that are less regulated may be more prone to wash trading.
High-Frequency Trading
High-frequency trading is the practice of conducting tens of thousands of trades per second. Thanks to faster internet connections and lightning-quick computers, high-frequency trading became possible. Wash trades could be more prevalent with high-frequency trading as there is less oversight than traditional trading platforms.
Cryptocurrency
Cryptocurrency is another area where wash trades may be pervasive. By inflating cryptocurrency trade volumes, investors are under the impression that the currency is popular and may invest. Market manipulators can make a lot of money by artificially boosting the crypto’s trading activity and price. The high volume of trading activity, price volatility and lack of oversight make cryptocurrency a prime target for wash sales.
Wash trade regulations are murky on a cryptocurrency exchange. The SEC and Internal Revenue Service (IRS) do not have clear-cut rules against wash-trading in crypto markets. Without regulations in place, traders can get away with wash sale practices on cryptocurrency transactions.
How to Avoid a Wash Trade
You can avoid wash trade transactions by keeping track of when you buy and sell securities, including the amount. The timeline for wash trades starts 30 days before the sale, the day of the sale and 30 days after the sale. To avoid a wash trade, you should wait 61 days before replacing the securities sold from your portfolio.
In addition to implementing a trading strategy, investors should stay updated with wash trade regulations. When you defy wash trade rules, you can’t claim ignorance as your defense.
Wash Trading vs. Market Making
Market making is a legal practice whereby dealers quote the prices they are willing to buy and sell securities. Market makers may purchase and sell securities within a short period of time to satisfy investor requests on demand. By making it easier for investors to trade securities, dealers and makers help keep markets liquid.
A wash trade differs from market making based on the trader’s intent. A market maker is typically trying to supply liquidity rather than artificially boost the demand and price of an asset with wash trades.
Avoid Falling into the Wash Trade Trap
Market manipulation through wash trading is an illegal practice. However, some investors may inadvertently complete a wash sale without realizing it. To prevent falling into the wash sale trap, investors should stay on top of wash trade regulations and pay close attention to the securities they buy and sell.
Frequently Asked Questions
Does forex trading cause wash sales?
When the intent is to take advantage of a tax deduction or boost market activity, a forex trade may result in a wash sale. In a wash sale, traders manipulate currency value to earn a profit.
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Does stock wash rules apply to ETF and ETN trading?
Stock wash rules formally apply to securities traded on an exchange, like stocks, bonds, ETFs and ETNs.
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How do you identify a wash trade?
Trader intent and results are vital factors that identify wash trades. A wash trade happens when an investor buys and sells the same securities in a short period and manipulates the market.
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The post What is Wash Trading? by Anna Yen appeared first on Benzinga. Visit Benzinga to get more great content like this.