1.1) What is the purpose of this FAQ?
This FAQ is *not* intended as a comprehensive
guide to trader status taxation. Rather, this
FAQ is a fast and easy way to get answers
to general questions, many of which are so
often misrepresented over the internet
1.2) What is Versus Purchase or VSP?
A method of identifying specific shares of securities to be
sold for tax purposes–also called “vs. purchase.” See
IR Reg. 1.1012-1(c)(3). If versus purchase is not specifically
stated at the time of sale, the IRS deems the securities sold
are made, within an account, on a first-in first-out (FIFO) basis.
See IR Reg. 1.1012-1(c)(1).
Typically, you can have your broker add a memo line to your
confirmation statement, per your instructions. For example, if you’re
selling the 100 shares you bought on March 31, 2008, ask your broker
to write on your confirmation that the transaction is a sale
“vs. purchase 3/31/08.” For online trades, you should immediately
follow up with a phone call to specify your instructions.
Exceptions to matching buys and sells on the FIFO basis exist for
mutual fund shares (for which taxpayers generally elect to use the
rolling average cost basis) and for publicly traded partnerships
(for which IRS Rev. Rul. 84-53 requires a rolling average cost
basis, referred to as a unified/unitary basis, in the PTP units).
An exception to the exception for PTP units is found in
IR Reg. 1.1223-3(c)(2)(i). The partner may make an
election under Regs. 1.1223-3(c)(2)(i)(C) as follows: “The
selling partner [may elect] elects to use the identification method
for all sales or exchanges of interests in the partnership
after September 21, 2000. The selling partner makes the election
referred to in this paragraph (c)(2)(i)(C) by using the actual
holding period of the portion of the partner’s interest in the
partnership first transferred after September 21, 2000 in
reporting the transaction for federal income tax purposes.”
1.3) What is a Wash Sale? (SEC definition)
Also known as a accommodation sale or a fictitious sale
is a security or commodity that is bought and sold, either
concurrently or within a short period of time, to create artificial
market activity with the intent to profit from the resulting change
in the security’s price. Wash sales are prohibited under
Section 4c of the Commodity Exchange Act.
1.4) What is a Wash Sale? (IRS definition)
The sale of a security at a loss and the purchase of shares
within 30 days while continuing to hold either a long or short open
position in the security. The IRS temporarily disallows (defers) such
losses for tax purposes. The IRS also extends the wash sale prohibition
to closing short sales. See The Wash Sale Rule for more detailed information.
1.5) What are “Cash-Settled Options”?
These are options for which no actual common stock is bought
or sold on behalf of the option buyer, rather they can be exercised
for cash only at expiration.
1.6) What are “Physically Settled Options”?
These are options for which actual shares
are bought or sold when the option is exercised.
1.7) What is the “trade through” rule?
The trade-through rule, which was first instituted in 1975,
was designed to make sure investors got the best
available price for their stock trade. A market system would not
allow one customer to “trade through” an existing order without
first matching that order. A customer’s order has to be routed to
the destination with the best price at the moment the order is
That sounds like a good idea on the surface, but the rule was
enacted before electronic markets existed. Though it’s moving in the
direction of automation, the NYSE is still at heart a manual system,
with trades handled by specialists in particular stocks.
Nasdaq, however, is fully automated, so while a quote on a Nasdaq
stock is currently executable, a quote on an NYSE stock is
considered an indication and not a firm quote.
The trade-through rule as it stands means that if you place an order
and the best possible quote is with a particular specialist on the
floor of the NYSE, then your broker is required to route your order
there. But a NYSE quote is not immediately executable–it’s more
analogous to an advertised price than an actual price.
Specialists are allowed to hold an order for 30 seconds before
either executing it or handing it off to another specialist—and
during that time, the price may change.
Executives at the NYSE have defended the trade-through rule, saying
it’s good for small investors. But Nasdaq members often charge NYSE
specialists with bait-and-switch pricing tactics so that orders are
routed to the NYSE, then executed at a worse price than what was
available at the time the order was entered.
The trade-through rule mandates that when a security is available on
more than one exchange, transactions may not occur in one market if
a better price is offered on another market. Defenders of the rule
portray it as an essential protection for investors, particularly
small investors who find it difficult to monitor their brokers’
performance. Opponents argue that its principal effect is
anti-competitive; that it protects traditional exchanges – where
brokers and dealers meet face to face on trading floors – from newer
forms of trading based on automatic matching of buy and sell orders.
The Securities and Exchange Commission (SEC) has proposed new
regulations that would modify the trade-through rule, which it
describes as antiquated, by allowing investors to “opt out” of the
rule voluntarily and by permitting traders on “fast” markets to
trade through (that is, ignore) better prices offered on
non-automated exchanges. The securities industry is divided on the
SEC’s proposal, but there is a consensus that amending the
trade-through rule could force dramatic changes in the way stocks
are traded, especially on the world’s largest market, the New York
Stock Exchange (NYSE). Committees in both the House and Senate have
held hearings on this and other market structure issues, most
recently in the House Financial Services Subcommittee on Capital
Markets, Insurance, and Government-Sponsored Enterprises on May 18,
1.8) Who are DMMs?
Designated Market Marker (formerly known as a NYSE Specialist) is a
participant that has the obligation for maintaining a fair and
orderly market in the price and trading of his assigned securities.
A DMM works both manually and electronically to facilitate price
discovery during the market opening, closing and also during periods
of substantial trading imbalances or instability.
1.9) What is the Order Protection Rule – Rule 611?
An upgrade of the trade-through rule passed in 2007. The Order
Protection Rule, aims to ensure that both institutional and retail
investors get the best possible price for a given trade by comparing
quotes on multiple exchanges. If a better price is quoted elsewhere,
the trade must be routed there for execution, and not “traded through”
at its current exchange.
1.10) What is the “tick” test?
Prior to July 3, 2007 Rule 10a-1 restricted when a short sale may be
executed. Tick-test rules dictated that a short sale could be made only
in two situations:
- When the price of the particular stock
is higher than the last trade price (an uptick)
- In a case where there is no change in
the last trade price. The previous trade price must be higher than
the trade price that preceded it (a zero uptick or zero plus tick)
Rule 200 of Regulation SHO was replaced
with rule 201 effective July 3, 2007 or July 6, 2007.
1.11) What is Naked Short Selling?
Naked short selling is selling short without borrowing the necessary
securities to make delivery, thus potentially resulting in “fail-to-deliver”
securities to the buyer. Naked short selling can have a number of
negative effects on the market, particularly when the fails-to-deliver
persist for an extended period of time and resulting in a significantly
large, unfulfilled delivery obligation at the clearing agency where
trades are settled.
This being akin to con job thievery, the SEC allows the well-heeled
players on the Street to practice naked short selling with relative
impunity. Consider this: If one were to sell prime real
estate, raw acreage, to an investor… Only to find out later
that the seller did not have perfected title to the land (or to make
this analogy closer – that the land did not even exist)? Then
when confronted by the bunko squad, offering the excuse “But sir, I
was planning to buy the land back after it declined in value.”
Nowhere in the world would such a scheme be accepted, rather the
perps would be locked up in the hoosgow immediately upon discovery!
But the SEC protects the thieves and actually provides the mechanism
that facilitates the activity.
The SEC denied the existence of naked short selling for years.
After many complaints and providing proof of abuse, such as seeing a
higher number of shares held short than were actually issued by a
publicly trading company for example, it became obvious that the
SEC’s claims were wrong. In 2005 Regulation SHO was
established to temper this abuse.
1.12) What is Regulation SHO ?
Regulation SHO replaces Rules 3b-3 and 10a-2, as well as certain
self-regulatory organization (“SRO”) rules governing short sales,
and modifies Rule 10a-1. Specifically, Rule Regulation SHO requires
short sellers in all equity securities to locate securities to borrow
before selling, and also imposes strict delivery requirements in
order to settle short sales. The regulation further includes a
temporary rule that establishes procedures by which the SEC
may temporarily suspend, on a pilot basis, the current
“tick” test and the short sale price test of any exchange or
national securities association for specified securities. Regulation
SHO also defines ownership of securities, permits the establishment
of aggregation units (thereby avoiding firm-wide determination of
net long and short positions) subject to certain requirements, and
requires broker-dealers to mark sales in all equity securities
“long,” “short,” or “short exempt.” Finally, the SEC voted to
eliminate the shelf offering exception in Rule 105 of Regulation M
under Regulation SHO, thereby prohibiting short sales covered by
securities offered off the shelf.
1.13) What is Regulation FD ?
Fair Disclosure, Reg. FD, went into effect August 15, 2000 to address the
selective disclosure of information by publicly traded companies and
other issuers. Regulation FD provides that when an issuer discloses
material nonpublic information to certain individuals or
entities—generally, securities market professionals, such as stock
analysts, or holders of the issuer’s securities who may well trade
on the basis of the information—the issuer must make public
disclosure of that information. In this way, the new rule aims to
promote the full and fair disclosure.
1.14) What is Give-Up?
A customer “give-up” is a trade executed by one broker for the
client of another broker and then “given-up” to the regular broker;
e.g., a floor broker with discretion must have another broker
execute the trade.
1.15) What is Give-In / Give-Up Management?
Trades accepted for your clearing account
with certain brokers are designated as give-in trades on your daily
statement. Information such as the executing firm and other relevant
trade identifiers are also noted on each give-in transaction. These
services allow clients to maintain relationships with different
executing brokers while reaping the benefits of centralized
clearing, such as improved risk management, simplified treasury
operations, reduced administration, easier trade confirmation and
consolidated margin requirements.
1.16) What is Buy Side?
The side of Wall Street comprising the
investing institutions such as mutual funds, pension funds and
insurance firms that tend to buy large portions of securities for
money-management purposes. The buy side is the opposite of the
sell-side entities, which provide recommendations for upgrades,
downgrades, target prices and opinions to the public market.
Together, the buy side and sell side make up both sides of Wall Street.
For example, a buy-side analyst typically works in a non-brokerage
firm (i.e. mutual fund or pension fund) and provides research and
recommendations exclusively for the benefit of the company’s own
money managers (as opposed to individual investors). Unlike
sell-side recommendations – which are meant for the public –
buy-side recommendations are not available to anyone outside the
firm. In fact, if the buy-side analyst stumbles upon a formula,
vision or approach that works, it is kept secret.
1.17) What is Sell Side?
The retail brokers and research departments
that sell securities and make recommendations for brokerage firms’
customers. For example, a sell side analyst works for a
brokerage firm and provides research to individual investors.
1.18) What is a Boiler Room?
A place where high-pressure salespeople use
banks of telephones to call lists of potential investors (known as a
“sucker lists”) in order to induce them to purchase speculative
securities, sometimes called “the stock of the day” that the firm
has a large inventory of, to be unloaded at significant profit to
the brokerage. It is called a boiler room as an analogy to a
pressure cooker due to the high-pressure selling.
1.19) What is a Bucket Shop?
A firm that uses aggressive telephone sales
tactics to sell securities that the brokerage owns and wants to get
rid of. The securities they sell are typically poor investment
opportunities, and almost always penny stocks. It is called a
bucket shop because originally these firms might execute trades all
day long, throwing the tickets into a bucket. At the end of the day
they would sit back and decide which customer accounts to award the
winning and losing trades to.
1.20) What is an Accredited Investor?
Generally speaking an accredited investor
is someone who earns $200,000 per year or has a net worth in excess
of $1 million.
Under the Securities Act of 1933, a company
that offers or sells its securities must register the securities
with the SEC or find an exemption from the registration
requirements. The Act provides companies with a number of
exemptions. For some of the exemptions, such as rules 505 and 506 of
Regulation D, a company may sell its securities to what are known as
“accredited investors.” The federal securities laws define the term
accredited investor in Rule 501 of Regulation D as:
- a bank, insurance company, registered investment company,
business development company, or small
business investment company;
- an employee benefit plan, within the meaning
of the Employee Retirement Income Security Act, if a bank,
insurance company, or registered investment adviser makes the
investment decisions, or if the plan has total assets in excess of
- a charitable organization, corporation,
or partnership with assets exceeding $5 million;
- a director, executive officer, or
general partner of the company selling the securities;
- a business in which all the equity
owners are accredited investors;
- a natural person who has individual net
worth, or joint net worth with the person’s spouse, that exceeds
$1 million at the time of the purchase;
- a natural person with income exceeding
$200,000 in each of the two most recent years or joint income with
a spouse exceeding $300,000 for those years and a reasonable
expectation of the same income level in the current year; or
- a trust with assets in excess of $5
million, not formed to acquire the securities offered, whose
purchases a sophisticated person makes.
1.21) What is so-called High Frequency Trading?
Powerful computers, some housed right next
to the machines that drive marketplaces like the New York Stock
Exchange, enable high-frequency traders to transmit millions of
orders at lightning speed and, their detractors contend, reap
billions at everyone else’s expense.
These systems are so fast they can outsmart
or outrun other investors, humans and computers alike. And after
growing in the shadows for years, they are generating lots of talk.
Nearly everyone on Wall Street is wondering
how hedge funds and large banks like Goldman Sachs are making so
much money so soon after the financial system nearly collapsed.
High-frequency trading is one answer.
And when a former Goldman Sachs programmer
was accused this month of stealing secret computer codes — software
that a federal prosecutor said could “manipulate markets in unfair
ways” — it only added to the mystery. Goldman acknowledges that it
profits from high-frequency trading, but disputes that it has an
Yet high-frequency specialists clearly have
an edge over typical traders, let alone ordinary investors.
1.22) What are Flash Orders and Flash Trading?
Flash orders are also called “step up” or
“pre-routing display” orders. The rationale for these order types is
simple: Better me than you. They allow a venue to execute marketable
orders in-house when that market is not at the national best bid or
offer, instead of routing those orders to rival markets. They do
this by briefly displaying information about the order to the
venue’s participants and soliciting NBBO-priced responses. Similar
to front-running, if there are no responses, the order can be
canceled or routed to the market with the best price.
All four markets with flash orders treat
these orders in a similar way. If they get a marketable buy order,
for instance, that would otherwise be routed to a market quoting at
the NBBO, they flash the order to some or all of their participants
as a bid at the same price as the national best offer. Exactly who
sees the flash, how that information is conveyed and the duration of
the flash vary by market. The maximum allowable time for a flash is
500 milliseconds, or half a second, although most of the markets
flash routable orders for under 30 milliseconds.
EXAMPLE: July 15, 2009 Intel had reported
robust earnings the night before. Some investors, smelling
opportunity, set out to buy shares in the semiconductor company
Broadcom. (Their activities were described by an investor at a major
Wall Street firm who spoke on the condition of anonymity to protect
his job.) The slower traders faced a quandary: If they sought to buy
a large number of shares at once, they would tip their hand and risk
driving up Broadcom’s price. So, as is often the case on Wall
Street, they divided their orders into dozens of small batches,
hoping to cover their tracks. One second after the market opened,
shares of Broadcom started changing hands at $26.20.
The slower traders began issuing buy
orders. But rather than being shown to all potential sellers at the
same time, some of those orders were most likely routed to a
collection of high-frequency traders for just 30 milliseconds — 0.03
seconds — in what are known as flash orders. While markets are
supposed to ensure transparency by showing orders to everyone
simultaneously, a loophole in regulations allows marketplaces like
Nasdaq to show traders some orders ahead of everyone else in
exchange for a fee.
In less than half a second, high-frequency
traders gained a valuable insight: the hunger for Broadcom was
growing. Their computers began buying up Broadcom shares and then
reselling them to the slower investors at higher prices. The
overall price of Broadcom began to rise.
1.23) What is Dark Pool Trading?
A Dark Pool Trading system is an internal
system which is intended to trade stocks privately with the
objective of liquidating large stock positions at lower costs. Many
of these systems have evolved into alternative trading systems ATS
(Alternative Trading Systems), where liquidity is reported to
reside, but cannot be seen with the naked eye. The sources of
dark liquidity include, ATS, crossing networks and other dark
pools, and unlike traditional liquidity sources such as stock
exchanges, trade on these systems and draw their prices from the
market, and in most cases do not have any market impact. Thus they
may not print their trade details back to the market essentially
because regulations do not currently require it.
In the recent past, the financial markets
have undergone lot of changes in terms of trading strategies, new
product innovations, the regulatory requirements, and a growth in
technology have led to increase in trading volumes. Along with the
volumes on the exchanges, the trading volumes of the dark pool
trading systems are growing every day. Today, there are more than 40
dark pool systems that are operational in US market.
The Dark Pool Trading systems, mainly used
by the institutional traders who trade in large volumes, help
institutional investors in getting more liquidity and less
transaction cost, strategies are not exposed to the markets- less
transparency, fund manager strategies are best implemented with the
use of algorithmic trading whereby best execution is possible. In
spite of these benefits, few issues like inadequate price
transparency, regulatory requirements and uniform information access
to all kinds of investors are still debatable.
Considering the complexity of these trading
systems in terms of technology, speed, functionalities and system
performance, it is very important that the functional testing along
with the gateways testing and performance testing need to be done.
1.24) What are Expert Networks?
For a fee, through Expert Networks, stock
market traders are introduced to consultants, insiders employed at
various public companies, who will divulge company secrets and
other material non-public information to the trader. Armed
with this information the trader can execute trades at favorable
prices, before the general public becomes aware of actionable
developments with the public companies.
On the surface, the Expert Network and consultants
are merely chatting with interested people about the
progress or lack of progress within their companies.
But when one considers the level of compensation received and the
dollar amounts paid by traders to partake in these casual
conversations with corporate insiders, it might beg credulity why a
trader would pay so much just for a friendly chat that resulted in
no actionable information, including material non-public information.
1.25) What is clawback?
The recovery of alleged illegal amounts from parties that
benefited from the alleged illegal activities of a financial enterprise.
The Government and/or the unknowing
Investors who were harmed by the actions can recover money
from those who profited, even if the party whom profited was unaware
that the financial enterprise with partaking in an illegal activity.
It could be that someday investors such as CalPERS
should be facing clawbacks for the substantial gains they have
earned over the years from their investments in hedge funds that
traded on material non-public information.
In theory they “should have known” that it is unbelievable for any
hedge fund to earn astronomical returns year-after-year based solely
on honest research, rather than being supplemented with short-term
trading based on material non-public information.
1.26) What is founder’s stock?
The shares of common stock that are issued in the
organizational minutes or consent of the board of directors of the
company when they are setting up the new business, adopting bylaws
and appointing officers. This is called “organizing” the corporation.
The people who get this initial stock are the “founders” as a general rule.
1.27) What is friends and family stock?
A company’s stock that is offered to preferred individuals,
prior to or concurrent with its initial public offering (IPO).
Issuers and bankers may offer “friends and family shares”
to business associates, family members or friends, prior
to the stock’s launch to the public, allowing them a stake
in the future success of the company. These shares may
represent a small percentage of an offering, typically less
than 5%, but can create significant gains for the holder.
Also called directed shares.
1.28) What is a cash event?
A buyout or an IPO of a company’s stock.