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401K 'day trading'?


Guest simbarat
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Guest simbarat

I work with a bunch of guys who swear buy this plan…. They on a weekly basis buy and sell into our company share offering though our 401K. Our stock, lets say XYZ, has an almost predictable, cyclical pattern where-by it will oscillate from $50 to $70 a share through out the year. They buy low and sell high for example 3 in the afternoon on Monday they will see its at $50, buy the end of the week or month it may be at $60 and they will sell.

Is there anything wrong with doing this through their 401K?? Won’t they have crazy capital gains tax to pay when they retire from all the buying and selling??? Am I better off sticking with regular 401K investments to my company stock, XYZ, or should I ‘day trade’ like my coworkers.

thanks

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I want to know what the company name is and the perceived oscillation time-frame.

By the way, capital gains within the 401(k) plan are not a factor. Whenever it is distributed, that amount will just be taxable income.

"What's in the big salad?"

"Big lettuce, big carrots, tomatoes like volleyballs."

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Guest simbarat

I should'nt have used the word 'oscillate'. I know of it as it is used in the stock picking investment world but I don't know enough about it to say that this stock predictable in its oscillations.

I rather not give the name of the stock, lets just say it is a major player in the pharmaceutical industry, that exhibits very little volatility which sort-of coincides with its predictability.

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If the stock truly had a predictable pattern that generated the opportunity for "guaranteed, risk free profit", you can be sure that a professional arbiteur will identify the pattern and trade ahead of you and your fellow 401(k) participants, until the profit potential is eliminated. Is there any legal, tax or regulatory reason why you shouldn't try this? No. Are there any practical reasons. Yes. It's stupid. This technique may have worked in the past, but that's probably just a coincidence. Stick with your regular investment strategy.

BTW, true "day trading" requires the ability to take margin loans on your account, because of the three day settlement rules. Margin loans are not permitted on 401(k) accounts, making rapid day trading even more difficult than it already is.

Jon C. Chambers

Schultz Collins Lawson Chambers, Inc.

Investment Consultants

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Guest dmj1998

Jon - I agree with you in principle, but I think that it is fair to say that this is not a true arbitrage situation. What these employees (and many long-term EE's at alot of the more well-known S&P 500 companies) know, is that there is a perceptible cycle to the stock price based upon the industry they are in. As an example, look at the charts for HMO's that dip in the summer and fall when they are crying poverty and raising rates as they negotiate new prices for the upcoming annual enrollment season. Their prices then tend to rise in the spring when the announce "record" earnings due to well-negotiated pricing strategies. The problem is, do you want to be doing this in your retirement plan if, hypothetically, you worked for Columbia/HCA and bought the stock just before their offices get raided?

The bottom line, though, is this is tantamount to gambling. Professionals do not get involved because it is not guaranteed and employees are usually blinded by the percieved knowledge of the company to not get out when they should (Enron, Lucent, Nortel, etc.).

True day trading also requires "real-time" access to the market, a feature that many plans do not offer. You're better off developing a long-term investment strategy, sticking to it, and sleeping better at night.

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dmj, you are correct that this is not a true arbitrage situation, and that was what I was intending to point out. Just because there is a perceived pattern, there is no reason that the stock must continue to follow that pattern. If there were such a reason, it would be an arbitrage opportunity, and the arbs would act in a manner that would destroy the truly predictable pattern. My point is that simbarat's colleagues believe that there is a truly predictable pattern, and they are trying to sell him on the same flawed concept. I'm encouraging him to avoid it. I think you agree with me on that point anyway.

Jon C. Chambers

Schultz Collins Lawson Chambers, Inc.

Investment Consultants

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Jon:

I think that in some cases, day trading may make sense. I have a personal friend that ran up $200,000 into over $20,000,000 in about two years.

Now there are extenuating circumstances, in that he is incredibily bright and devotes all his spare time to it, but there are some rare circumstances where it makes sense.

That being said, I've read where the typical day trader loses, rather than makes money on those activities.

Kirk Maldonado

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I think it would be better to say that, in hindsight, sometimes day trading works out (Hey - I'd risk $200 day-trading if I thought I could turn it into $200,000).

To say it makes sense is to say that you have more information than the market for an extended period of time and can make returns in excess of your fees.

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Hi Kirk. The SEC did an interesting (but small scope) study of day traders about 18 months ago, and concluded that about 85% of the day trading accounts that they studied would be bankrupt within three years. Between margin loan costs and trading charges, the accounts typically ran up costs equal to 60-80% of invested principal each year. Essentially, the SEC concluded that there was no way that trading profits would be able to overcome costs. According to the SEC study, the only people really profiting from day trading were the brokerage firms supporting the trading.

The SEC did say that the remaining 15% of studied accounts had opportunities to be profitable. These accounts:

traded more moderately,

didn't risk a significant percentage of principal on a single trade or security, and

carefully managed trading costs and trade execution.

Based on everything I've read about day trading, I think it's awfully difficult to do profitably. If you use the standard definition of day trading (which presumes that all long and short positions are closed before the end of each trading day), you are essentially betting that your individual trading abilities are sufficient to capture enough profits from positions taken for minutes or hours at a time to cover brokerage fees, margin loan costs, and also generate a reasonable profit. Do these strategies generate a broad range of returns, from -100% (losing it all) to +1000%? Yes they do. Do more people lose 100% than gain 1000%? I think they probably do. Do the people who lose 100% talk about it much? Probably not. Do the people who earn 1000% talk about it? I'm sure they do. The net effect is that people perceive day trading to be much more successful than it really is, because we generally only hear the success stories.

Jon C. Chambers

Schultz Collins Lawson Chambers, Inc.

Investment Consultants

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I agree with Jon 100%. What are your qualifications for managing money? In my experience with plans that allow these self-directed accounts, I see participants losing their retirement savings because they think they are smarter than your professional investor. For some reason people think they automatically know how to invest professionally when they do not have the slightest clue. I personally think that it is best to turn your account over to a money manager and let them do your investing for you. I think you will see that they have average to above average returns compared to the market.

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Some five or six years ago, the company I was then with was handling the 401(k) for a major computer manufacturer. One individual in particular was heavily into market timing his company stock in the plan, moving back and forth between a full stock position and a full money market position about every other day.

At the end of the plan year, one of my employees calculated that his return was slightly over 4%, and that if he had just left the $ sitting in an equity index fund available to the plan, he would have made over 30%.

This guy probably felt pretty good about himself that he was able to make a positive return, and it's true that he made money on the whole. It's also true that he could have made a lot more, and saved himself (and, more importantly, us!) a lot of time and effort by taking a more reasonable approach.

I know it works for some, but whenever I hear a rags-to-riches story, I think of that guy.

- Joe.

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Guest dmj1998

simbarat, thanks for the posting. it appears that the stock has traded in a tight range ($10-$15) over the last two years. I think a technical analyst would tell you that is a pretty crappy pattern to try and make money off of and I don't think its worth losing sleep for the amount of effort you would be doing to try and catch a $4-$5 dollar swing each time. besides, what does your employer think about your coworkers watching the stock all day instead of making better products?

jon - i do agree with you. true day trading itself is actually a very good example of an arbitrage situation you describe. It basically started as a guaranteed way to make money until people (and wall street firms) caught on and now it is just plain gambling. if anyone is curious, do a search on on the web for some history about NASDAQ's Small Order Execution System (SOES for short), which was the forerunner to the current day model.

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Guest simbarat

Thanks everyone for the input

The '4-$5 dollar swing each time' that dmj points out is pretty acurate as to what they are doing. The guys who are doing it have been here for many years and therefore have a lot in their 401K. I'm guessing at times they will make a $4 or $5 stock swap with $20,000 at a time. i.e. stock buy in at $55, then sell a couple of weeks later at $60, to get a gain of near 2K.

Sticking to ones game plan of dollar cost averaging/conistent investing, one could net that 2K over time anyway. Plus (as I am wondering), to achieve that simple 2K return, their buy/sell swaping between the company stock and fund sweep in their 401K, will represent an unneccessary capital gains tax (upon withdrawl of funds at retirement).

All too risky and unpredictable for my shoes, as everyone has pointed out.

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Guest dmj1998

simbarat - its good to see that you've apparently seen the light the shines from the benefits of long-term investment planning, but please remember, as Blinky pointed out, there are no capital gains exposure to trading investments within a qualified retirement plan. Unlike a retail account where you have to account for gains and losses each year with Uncle Sam, there is no tax implications for you until you actual take possession of the funds and, in almost all cases, it will result in ordinary income and not capital gains. The only time capital gains is a concern is when you distribute your account and it includes company stock. When that time comes, please seek a reputable tax advisor who can discuss your personal situation and your options at that time.

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Whether or not this is a risk way to make money depends on how the plan books the sale of the stock on its records. Some plans record the sale of the stock based on the closing price on the prior day. Astue employees will log onto the system shortly before close and check the price of the stock. If the price is up over the prior days price they will buy or sell and log a profit relative to the price as of the close of the prior day (without paying any income tax or trading costs). Eg. if on day one the closing price is 39 and at 3:50 on day two the price is 40 the employees could buy the stock on day two at 39 locking in a profit of $1 when the stock is sold on day 3. There was an article in the WSJ about a year ago about a 401(k) plan where the employees gamed the system by selling stock against the plan (the stock was a form of inventory) which resulted in the plan losing several million $ (presumabley the losses were spread among all participants). The employees did not do anything illegal because the plan permitted the practice. The plan was amended to prevent this practice. So check to see how the plan determines the price of the stock.

Despite what the investment advisors may claim this is not a very difficult thing to do. It is an application of the only wall street rule that counts: buy, low sell high.

Also there is capital gains on employer stock on the net unrealized appreciation of the stock after it is distributed to the participant at a maximum rate of 20%.

mjb

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MJB--

While your observation is correct for plan's using this kind of pricing system, I hardly ever see this approach in the market. Most service providers make specific identification of each trade, so the selling price is what the individual sells for. Another common approach is to take the average price of all trades during the day. Very few plans let you use the prior day's value.

Another misconception is that you don't pay trading costs. Many plans net out the brokerage commission when they figure the trading price, but the commissions are paid anyway. While it's possible that the sponsor might absorb the commission, I haven't seen this in practice.

Finally, in order to take advantage of the NUA pass through rules, you have to have unrealized appreciation. If you sell the stock, your gains become realized.

Jon C. Chambers

Schultz Collins Lawson Chambers, Inc.

Investment Consultants

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Jon - my response intended to demonstrate that many 401(k) plans have strange practices in allowing employees to buy or sell stock some of which create what you investment folks call market inefficiencies which can be used to the employee's advantage. Some plan provisions are adverse to the employees ( e.g., enron provision forbidding employees to sell ene stock before attaining age 50- which should have been considered a violation of age discrimination laws). Therefore employees and their advisors must review the plan provisions pertaining to purchase/sale of employer stock before buying or selling the shares.

The larger problem which needs to be addressed by investment advisors is at what point does an employee become over concentrated in employer stock and how do you hedge/unwind the position. Most of the enron employees had all of their savings in ene stock either in the 401(k) plan or through stock options.

In my example there should be no trading costs because the plan was using stock from inventory not stock traded on an exchange. I am also interested in your comments on NUA since employers only keep records of cost basis for tax reporting.

mjb

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Guest dmj1998

mjb - i agree with jon in that i have never seen a plan price their company stock in a qualified plan that way. when i read your post, i had a vision of a small employer and his broker coming up with a nice way for the small group of EE's (including the "owner") to make some easy money at the company's expense. any cursory review of the plan financials would have shown that this was not a fiscally prudent way to run the stock fund. Even with no direct brokerage costs, this would wreak havoc on the balance sheet.

i think that investment advisors already have a clear understanding of what constitutes "over concentrated" - the consensus is around 10%. the problem is twofold - how do lead the horse (participant) to the water (advisor) and then who says that the horse will drink (the advice)? prudent plan sponsors and most investment media types have been harping on this off and on for the last 5-6 years, but situations like enron, lucent, coke, p&g still occur.

as for your comment on age discrimination, i think that the federal laws on age discrimination came after erisa, so it would probably prove to be an interesting discussion for the supreme court to decide.

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Guest simbarat

dmj, I am lost...........

"..there is no tax implications for you until you actual take possession of the funds and, in almost all cases, it will result in ordinary income and not capital gains. The only time capital gains is a concern is when you distribute your account and it includes company stock."

If I sell a stock for a gain, I will incur a capital gain correct????? Yes, if it is in a 401k it will not be taxed...YET, but when I take it out (or distribute it as you say) it will. How can it be taken out as income and taxed as such????

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Guest dmj1998

simbarat - a 401k plan is essentially an agreement between you and your employer to defer receipt of monies that would normally be in your paycheck until sometime in the future, hopefully after you retire. when the money is deferred, it is put into a trust account for your benefit. in the past, participants had very little control over that money and how it was invested. these days, participants have been able to get a great deal of control over it and can decide from many different investment options. this level of choice has clouded the issue that the money is still technically not yours until some qualifying event occurs that would allow you to receive it, like termination or retirement. once a qualifying event occurs, you can take receipt of the monies and the irs views it as receipt of monies that should have been in your paycheck a long time ago, so it is treated as ordinary income just like your paycheck.

the upside occurs when your deferrals have grown to vast sums due to prudent investment choices over the years. the downside is that, in exchange for longterm growth of tax-deferred investments, participants give up the right to be taxed at traditionally lower longterm capital gains rates.

despite the fact that you may treat your 401k like a brokerage account, it is not. trades within the 401k account are not reported to the irs, sec, or anyone else (except maybe the plan sponsor) and not subject to taxation at the end of each year like a retail brokerage account is.

hopefully, my colleagues will not pillory me for such a simple explanantion. there are many nuances that would change some of my descriptions, but the essence is still the same.

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dmj1998 - What i I keep trying to empahsize is that many plans have strange provisions regarding trading of employer stock which are overlooked because no one reads the controlling documents. I am not questioning your statement that it is not a ficscally prudent way to run the plan (since the employees where able to trade against the plan for a no risk profit) but making u aware that there are many plans that have quirks in how the company stock is traded which creates a advantage for one side or the other which employees and their advisors should be aware of. By the way the plan I cited was for a public company. Incidentally some employees hire their own investment advisors to trade company stock for their 401(k) accounts via a power of attorney.

Your 10% concentration is totally unrealistic in the real world since younger employees don't have discretionalry funds outside of the plan to invest hence will be 90%+ invested in employer stock and middle aged employees will be sitting on gains from years of tax free investments which will be well in excess of 50% of total investable assets which will not be easily sold because of plan restrictions. You also seem to forget that most large companiess go though cycles in stock price which makes continuous purchases at low prices a form of dollar cost averaging. E.g., in 1991 Citigrup was selling at the equivalent of of less than $2 a share- today it is at $50. Should Citigroup employees have stopped buying C in 1991? IBM was down to about $10.50 a share in 1993 today it is 110.

mjb

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The concentration issue doesn't have a single answer. It varies by individual. Some advisors believe that no retirement assets should be invested in company stock, because the employee's earnings come from the same source that would support retirement assets. If the company goes bankrupt, retirement assets become worthless at the time they are most needed, when the employee is laid off. Personally, I believe that employees should invest in company stock only what they can afford to lose. Further, employees in formulating their retirement plans, employees should expect nothing from company stock. If the stock becomes worthless (like in the Enron case), employees are still ok. If the stock does well, employees have excess assets in retirement--not a problem.

Regarding the ADEA, there shouldn't be an issue for Enron, since the ESOP diversification rules (which are driving the age 50 diversification rules) are specifically exempted from ADEA. The Enron case will turn on general prudence rules, potential false or misleading statements made by execs, and the decision to black out trading during a period that execs knew, or should have known, that material information driving down the stock price was likely to come out.

Personally, I think that application of insider trading rules should be sufficient to require the senior execs to disgorge their trading profits on Enron stock. The political problem will be what to do with these funds if and when they become available. Should they go to creditors, to employees, to other stockholders? A lot of people got hurt, and I doubt there will be enough money to make everyone whole.

Regarding capital gains, the rules that apply to qualified plans are different from the rules that apply to a taxable brokerage account. I don't have time to discuss all the nuances. Suffice it to say that distributions from qualified plans will be 100% ordinary income, unless the distribution is in the form of company stock (ignore A-tax contributions for now). As dmj comments, your trading gains look just like your contributions for tax purposes. And trading gains aren't taxed until they are distributed from the plan. My comment on NUA presumes that funds are distributed from the plan in the form of company stock. Under these rules, you are only taxed on the cost basis of the stock distributed, gains are taxed when the stock is subsequently sold. To clarify for MJB, if you have actively traded your company stock, your cost basis is probably close to the value distributed to you (I'm presuming you bought back in close to current market value), hence the benefit you get from NUA is small.

Jon C. Chambers

Schultz Collins Lawson Chambers, Inc.

Investment Consultants

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