Saturday, October 11, 2008

"Mind" -> Account For Yearly Gains On Etrade

I have written before how I believe that having both stocks and working covered calls can work to your advantage. However, once you get into using these tools for making money, you might not realize two very important things:

1. It becomes a little more difficult to keep track of how much money you've made or lost.

2. You absolutely need to clean up your account at the end of the year, or you'll be paying a lot more cash than you want to to the government.

Let's talk about both of these issues.

This is because the numbers that Etrade show are based on what you paid for stock, and they are not based on how much your cash position has changed over the year.

Let's say I walked into the tax year with $10,000 that I had in my pocket. On January 2, I put this money into etrade and bought myself $10,000 worth of stock by buying 100 shares of $100 stock at XYZ corporation. Once I had the 100 shares of stock, I then turned around and sold the cover calls on the stock for an additional $1000. Since I now had $1000 in my pocket, I decided to buy ten more shares of stock of XYZ. So, I have $11,000 worth of stock.

Etrade shows a running total of what you made and what you haven't made in the market. So, after the covered calls have expired, it will show you that you have $1,000 worth of gains because I sold the covered calls. In this case, let's say that it is short term because covered calls are always this. So, Etrade would show that I made $1000 short term gain.

However, let's us say that my stock, which was worth $11,000 at $100 per share, fell to $90 per share. So, I would have $9900 worth of stock. Since I bought it for $11,000, I have lost $1100. My portfolio is down 10%! What a horrible year. I lost a bunch of money.

Or have I?

If you remember, I walked into the year with $10000. If I sold all of my stock, I would get $9900. In fact, since I buy dividend stock, I also got a dividend on all of the stock. This gave me another $300 for the year (after tax). This means that I entered the year with $10000, and I exited the year with $10200. I didn't lose $1100. I made $200.

So, you need to look at all of the data to truly understand what is happening.

The challenge with Etrade is that it doesn't say that "hey you had $10000 at the beginning of the year." Instead, it will simply give you three sections that you need to check:

1. The amount that is in your banking account (Seen on the home Account Tab)
2. The amount that is in your stock account and current position (Security Tab)
3. A running total of short/long gains in your Security tab under the sub-tab.

So, even if you didn't write down how much money you had at the beginning of the year, the overall answer is pretty easy. Here are the steps:

1. Figure out how much you are worth if you liquidated everything today. In the case above, if I liquidated everything today, I would have $9900 worth of stock.

2. Now you need to figure out how much you had at the beginning of the year. This is simply taking your liquidated value ($9900) adding the losses of $1100 because the stock went down and then subtracting the short term gains from selling your covered calls.

$9900 + $1100 - $1000 = $10000 your starting cash

Now, to get your performance during the year it is simply (ending cash)/(starting cash) = 1% loss on your portfolio before we got our money from our dividends.

So, life isn't all that bad unless you forget that Uncle Sam is coming after those short term gains. This is a major issue, and one you must not get surprised on. One part of the tax code that really boths me is the fact that Uncle Sam makes it so he can get the maximum amount of tax.

Let's say that you have a job where you are making $100,000 per year. Uncle Sam and Uncle California says that you need to pay them 35% of this money to them. So, you have take-home pay of $65,000. However, they see that you had all this money from selling covered calls in the market. According to them, you made an additional $1000 in the stock market. This is income, therefore they are going to come after it. However, this is a special type of income. It was considered "easy money" and you make a big salary of $100,000. Since this was easy money and you are making a good job, they will take roughly 40% of your $1000!

Now, lets go back to our example:

You started with $10000. If you sold the stock at the next year for $90 per share, you would get $9900. So you lost $100. This isn't all that bad, until you find out on your TurboTax that the government wants another $400! This is because they say that "you made $1000 by selling the covered calls last year." So by the time that you pay your money to the government, you find out that your 1% (or $100) loss has gone to a 5% (or $500) loss. $100 because you sold the stock and the other $400 because of the government.

However, you can try and miss most of this burden.

At the end of the tax year, let's say that you knew that the stock was down and that the government was going to tax you on all your short term gains. In this case, you have a $1000 gain coming, and on December 30th you see that the stock is at $90 and you know that the stock is going to be flat for a while.

At this point, you need to sell part of your stock to register that you have a loss. Let me explain it this way. The goverment will allow you to "offset" the gain from options if you have a loss. So, all you need to do is say "well, I need to show the government that I had a loss." You do this by selling your stock that is under water to the extent that it balances out the gain.

In our case, if the stock is $90 on December 30th, we are losing $10 per share for every stock that we sell. Therefore, if we have $1000 of gain that we want to cover, we need to sell 100 shares. The $1000 in money we made in the cover calls is offset or covered by the $1000 we lost by selling the shares.

So you walk out of the year with:

$9000 from the stock that we just sold
100 shares worth $90 per share

Total = $9900

Now, since we have neither gains or losses on this, Uncle Sam charges us absolutely nothing. So by doing this one simple act, you have saved yourself $400 or 4% of your money. This is a massive difference.

Now, this is where the tax code starts to have a massive dorking effect on the economy. This is going to be a bit complicated, but stay with me. In the above example, I was assuming that the stock price was going to be $90 exiting the year and $90 during the start of the new year. However, lets say that I had a perfect time machine. I knew that the stock price was going to be $90 on Dec 30th, but $92 on January 3rd. So, if you waited just 5 days, you could sell he stock for $2 more. Would you wait?

Well we just did the first case. In this case, we would have $9900 in money left over. But what about the case where we waited?

In this case, lets say that we held our stock until January 3rd and sold. So you would have

110 shares * $92 = $10120 worth of money. However, the government still thinks that you made $1000 last year on the options, therefore, they still are going to charge you another $400 for the money you made last year, regardless if just 3 days into the new year you sold the stock for a loss. So, your net gain?

$10,120 - $400 = $9720 or $180 worse than if you had sold for $2 less just 5 days ago!

This fact is not miss on anybody that is handling money a lot.

Always clean out your accounts at the end of the year

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