The Van Tharp Institute

April 20, 2005 — Issue #216

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In this Issue:

Trading Tip

When Day Trading Just Plain Makes Sense By D.R. Barton, Jr.

Tax Tip Self-Employment Tax on LLCs and Limited Partners
Listening In...

Confidence 

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Trading Tip: 

When Day Trading Just Plain Makes Sense

Trading Tip

by  D. R. Barton, Jr.

“Few enterprises of great labor or hazard would be undertaken if we had not the power of magnifying the advantages we expect from them.”

-- Samuel Johnson

The eulogy for day trading has been written many times in the past several years.  Feeling the heat from the Wall Street vanguard (who were having their profits margins cut by hoards of stay-at-home traders), regulators made it tougher for the “small player” to qualify.  Day traders have been belittled in the press as gunslingers.  And the list goes on…

So why does day trading continue to thrive?  Statistics show that a smaller cadre of day traders are now trading more share volume in absolute numbers than the vast hoards who had taken to computer screens at the turn of the millennium.  Day trading has some inherent advantages that suit the temperament of a large number of traders.  Let’s take a look at these advantages and see if this style of trading may have a place in your trading plan.

Advantage #1:  No overnight risk.  For a trader who is trying to stay in the game for the long haul, this is one of the biggest natural advantages in the trading world.  While we can understand this advantage intuitively (sleep better at night, etc.), let’s see if the concept bears any fruit quantitatively.

I used the excellent software that is under development by Chris Anderson and Van Tharp called Know Your System and tested using a suitable proxy for overnight risk.  Here’s the methodology:  Test two similar hypothetical trade distributions.  Each distribution has the same expectancy and is tested across the same number of trades.  The only difference is that the first distribution simulates intra-day trading and has its biggest loss as –1.5R, while the second distribution used represents the effect of taking on overnight risk by including a  –5.0R loss in the distribution.  This simulates having a one-dollar stop and when a company pre-announces reduced earnings and opens down five dollars.  Here is are our starting data:

·        Percent wins:   55% for both systems
·        Expectancy:   0.12 for both systems
·        No. of trades: 500 per year for both systems
·        Biggest loss:  -1.5R for day trading system, -5.0R for overnight risk system

What were our results?  As you can imagine, the volatility of our equity curve increased greatly when we added the possibility of a big loss.  Our average drawdown doubled, while our average gain stayed the same.  This alone is significant.  But the increased volatility had a much more telling effect; the optimum risk size (defined as the amount of equity that we could risk per trade to achieve the best reward-to-risk ratio) was 2.5 times smaller for the distribution that included overnight risk.

Advantage #2:  Frequency of trade.  We can make a good comparison of any numbers of systems if we know the expectancy and the frequency of trade of the each system.  For those of you not familiar with expectancy, it is a measure of how much a system makes per dollar risked.  In the example above, you make 0.12 dollars, on average, for every dollar risked.  (For more information on expectancy and frequency of trade please refer to Chapter 13 in “Safe Strategies for Financial Fre-edom”.)

Those of you who are familiar with expectancy calculations may have looked at the numbers in the previous section and thought, “an expectancy of 0.12 is very low.”  But remember that expectancy must be coupled with frequency in order to provide a meaningful comparison.  Recall that we assumed 500 trades per year using this system.  At that frequency this could be very profitable system, returning 60 percent per year if one risked one percent per trade.

Remember that high trade frequency is a double-edged sword.  It makes systems with even small expectancies very profitable.  But it also turns systems with negative expectancies into money pits.  Having systems that work is important in any style of trading, but in day trading, using a strategy that doesn’t work can cause rapid disaster.

Advantage #3:  Immediate feedback.  This advantage tends to separate the day traders from the swing and position traders.  For many folks, immediate feedback is a very reassuring characteristic.  Lessons are learned more quickly.  Positive actions are re-enforced more quickly.  For action-oriented personalities, day trading is a perfect fit.

Day trading is not a style that suits everyone.  But for those that thrive on immediate feedback and can make quick decisions, the benefits are many.  I talked last week about one of the best traders that I know.  Brad Martin, who was a floor trader at in Chicago for 14 years has left the floor and used his trading skills on the electronic platforms.  He puts the advantages discussed above to work every day.  For more information on Brad, see last week’s article by clicking here.

For those of you who are interested in Day Trading, Brad and I have designed a workshop that gives you detailed written systems that can jump-start your trading.  And we take you through real-time simulations to help you learn these strategies in a hands-on fashion.   For more on this workshop click this link.

Brad and I have also put together a Swing Trading workshop that is really incredible.  It is filled with detailed trading systems that we both use.  And we teach those systems by taking you through trading simulations where you apply the strategies along with us on real market data – you start building your confidence right in the workshop!  For more on this workshop with Brad’s proven strategies and thought processes,  click here.

D. R. Barton, Jr. will be teaching the upcoming Professional Tactics of Day Trading Course, May 14-16, 2005. 

He is the Chief Operating Officer and Risk Manager for the Directional Research and Trading hedge fund group. D. R. has been actively involved in trading, researching and teaching in the markets since 1986.  D. R. has taught extensively in many investment areas including intra-day trading, swing trading, and cutting edge risk management techniques. 

His writing credits include co-authoring Safe Strategies for Fin-ancial Fre-edom and co-creator and contributing author on Fin-ancial Fre-edom Through  Electronic Day Trading. He also writes a stock screening newsletter called Ten Minute Trader.

Editors Note: Throughout the issues you will see certain words with odd spellings, such as Fre-edom and mort-gage. This is because spam filters are likely to block message that contain certain words and this is one solution.

Tax Tip

Tax Tip of the Week

Self-Employment Tax on LLCs and Limited Partners

by

Stephen S. Meredith, CPA, PLL

 

Do Limited Partners and LLC Members pay Self-Employment Tax?  At this time, the answer is not so easy to explain for LLC’s.

In the early 1970’s the Self-Employment Tax rate was low and only applied to a small amount of wages.  Everyone who invested in a Limited Partnership wanted to include their income as earned income to increase their Social Security Benefits.  Congress passed a set of laws in the mid-1970’s to address this issue because they felt that investors should not count this “passive” income as earned income.  Internal Revenue Code section 1402 addressed some of these issues.  Specifically, section 1402(a)(13) states that limited partners may not include any distributions, except guaranteed payments, as self-employment income.

LLC members have limited personal liability by State law in most states, just like limited partners. LLC’s generally file partnership income tax returns unless they are a single member LLC or make an election to be taxed as a corporation.  Most states which have passed Limited Liability Company statutes say that if an LLC member actively participates in the day-to-day operations they still have limited liability.  Each state has had the Internal Revenue Service review their State Limited Liability Statute to get a written opinion as to whether they will be taxed as a limited partnership, and all have a letter saying they will be taxed like limited partnerships.

The Internal Revenue Service tried to clarify whether LLC members who worked in the business had to pay self-employment tax in 1997.  They issued proposed regulation 1.1402(a)-2 which basically said that LLC members would be subject to self-employment tax if they did one of several things; had some personal liability under state law, had authority to enter into contracts on behalf of the LLC, or worked more than 500 hours in the LLC per year.  They also said that members in LLC’s that were in various consulting fields would automatically have all profits classified as self-employment income.

Congress saw this as applying self-employment tax to people who actually worked in the business, which was alright, but also to any professional in any one of the consulting fields, which they did not like.  Congress passed the Tax reform Act of 1998 and instructed IRS that they could not implement the proposed regulations and gave them several years to propose new regulations.  IRS has never proposed new regulations.  Unfortunately, when doing an audit many IRS examiners are still using the proposed regulations that Congress struck down.

That leaves us with the same situation that we had before 1997.  LLC’s are not defined in the Internal Revenue Code at all, unlike limited partnerships; they are simply an organization existing under State law that is taxed as a limited partnership.  Limited Partnerships are not permitted to let limited partners pay self-employment tax except on Guaranteed Payments.  Section 1402(a)(13) is clear and unequivocal.

An aggressive tax preparer might take the position that none of the LLC or Limited Partner income is subject to self-employment tax under 1304(a)(13), and be correct.  A conservative tax preparer might take the position that all earnings are subject to Self-Employment tax because the person worked in the business full time and would be considered partially or fully liable under State laws for the business, and be correct based on State law.  The middle road, and easy solution, is to pay the members a Guaranteed Payment, maybe a monthly draw, which is equal each month and reflects the amount of work they do.  Then they could take any other profits and not be subject to the Self-Employment tax.

Also be aware that if you take the aggressive position, you may not be able to use the cash method of accounting for the tax return.  Any partnership which allocates over 35% of losses to limited partners is subject to the tax shelter rules, and must use the accrual method for their taxes.  This is not a problem if you have profits to allocate.  See sections 448, 464(e)(2), and 1256(e)(3)(b).

Another solution is to file form 8832 and elect to be taxed as a corporation.  You can also simply file form 2553 and make the election to be taxed as an S Corporation.  If you file form 2553, form 8832 is not needed.  Being an S-Corp has the added advantage of preserving the flow-through nature of the business income and expenses, while permitting the owner to take a salary, do tax withholding, and avoid the whole self-employment tax issue.  As long as a reasonable wage is paid, the S-Corp profits won’t be presumed to be self-employment income.

The IRS continues to audit LLC’s on the self-employment tax issue and tries to apply the proposed regs that were abandoned.  The IRS announced over a year ago that they were starting an initiative to examine S-Corp returns on the reasonable wage issue.  To be safe, consult your own tax advisor regarding how they are preparing you returns and ask about the risk involved in these various positions.

Stephen S. Meredith is a CPA in Richmond Virginia.  He specializes in preparing income tax returns for all types of businesses, individuals, estates, and trusts.  He also consults with new business owners on how to properly structure their business to get the maximum benefit from current tax laws.  Steve deals with many stock market and real estate investors.  He has clients nationwide and lectures regularly on tax topics. He is often a featured speaker at Van Tharp's Infinite Wealth Workshop. Contact Steve@SteveMeredithPLLC.com

 

Listening in....

Excerpts from Dr. Tharp's Mastermind Discussion Forum

 

Confidence 
Author: Scott 

I have developed 3 e-mini daytrading systems that suit my personality. Each system trades only once per day, if at all, and between the three systems, the likelihood of trading on any given day is 80%. I developed them last year, they are relatively simple and all three backtested well. For the last 100 days, I have monitored their results (not actually trading and not changing the systems) which have been as follows on a combined basis trading one contract per system:

150 trades
62% winners
0.50 expectancy
$15,500 net gain, net of commissions
$1,200 largest winning day
$375 largest losing day

My question is this: How does one gain enough confidence to trade the systems and to stick with it through drawdowns? It seems almost like religious faith - I can't prove God exists yet I still believe. I can't prove my systems will work in the future, so I have a hard time believing. Is it that I am afraid of losing in reality, or lack of faith in my systems? Is the only way to gain enough faith/confidence by actually doing it and proving to yourself that they work?

Scott

Reply To This Message 

Re: Confidence 
Author: PMK 

You have basically done everything you can to validate your system before committing real funds. In order to take the 'leap if faith' to real trading maybe the following thoughts will be useful.

Firstly, in addition to knowing your system has worked historically, do you know why your system works or has worked? What are the fundamental reasons why trading it should make money? If you know this you can then monitor the hypothesis for changes that may invalidate the reasons for your system continuing to work. If it is simply based on pattern recognition, that is a weaker argument for it to continue to work.

Secondly, what is the volatility of returns historically for your system? (standard deviation of moving average of expectancy is a good guide). This can help you through losing periods if you know the results are still within the 'normal' distribution of your system rather than the system being broken.

Thirdly, start as small as you can to convince yourself that your system can make money net of commissions and other trading costs. Trade only 1 contract for a while even if your position sizing algorithm says you can risk more.

Lastly, you are in a much better position than the 'does God exist' analogy. You know your profitable trading system has existed in the past, and does right now, and are just taking the leap of faith to believe it will continue to exist when you risk real money. There is no reason why the system should suddenly stop working if you trade it, since the market doesn't even know (or care) whether you are trading your system or not.

If you do trade your system with real cash be sure to monitor any actual deviation you make from the system as tested/defined now. You will find that you will initially make implementation errors that may be great enough to nullify any profit the system should have made. This would mean that it is you, not the system that is not working and you should have the courage and persistence to persevere. Also it is useful to have a pre-defined cutoff point where you will suspend trading and evaluate everything if you lose this amount of capital. This cutoff point should be larger than the historical maximum drawdown of your system so that it should not be hit if the system performs as poorly as it ever has (as defined by the normal deviation of results mentioned above).

Hope this helps!

Editors Note: Click  here to read more  responses on  this topic. 

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