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Trading Basics

Trade = Buy or Sell

To trade means to buy and sell in the jargon of the financial markets. How a system that can accommodate one billion shares trading in a single day works is a mystery to most people. No doubt, our financial markets are marvels of technological efficiency. et, they still must handle your order for !"" shares of #cme $um%uats with the same care and documentation as my order of !"",""" shares of &ega'orp. ou don(t need to know all of the technical details of how you buy and sell stocks, however it is important to have a basic understanding of how the markets work. )f you want to dig deeper, there are links to articles e*plaining the technical side of the markets.

Two Basic Methods

There are two basic ways e*changes e*ecute a trade+ ,n the e*change floor -lectronically There is a strong push to move more trading to the networks and off the trading floors, however this push is meeting with some resistance. &ost markets, most notably the N#./#0, trade stocks electronically. The futures( markets trade in person on the floor of several e*changes, but that(s a different topic.

Exchange floor
Trading on the floor of the New ork .tock -*change 1the N .-2 is the image most people have thanks to television and the movies of how the market works. 3hen the market is open, you see hundreds of people rushing about shouting and gesturing to one another, talking on phones, watching monitors, and entering data into terminals. )t could not look any more chaotic. et, at the end of the day, the markets workout all the trades and get ready for the ne*t day. Here is a step4by4step walk through the e*ecution of a simple trade on the N .-. !. 5. ou tell your broker to buy !"" shares of #cme $um%uats at market. our broker(s order department sends the order to their floor clerk on the e*change. 6. The floor clerk alerts one of the firm(s floor traders who finds another floor trader willing to sell !"" shares of #cme $um%uats. This is easier than is sounds, because the floor trader knows which floor traders make markets in particular stocks.

7. The two agree on a price and complete the deal. The notification process goes back up the line and your broker calls you back with the final price. The process may take a few minutes or longer depending on the stock and the market. # few days later, you will receive the confirmation notice in the mail. ,f course, this e*ample was a simple trade, comple* trades and large blocks of stocks involve considerable more detail.

)n this fast moving world, some are wondering how long a human4based system like the N .- can continue to provide the level of service necessary. The N .- handles a small percentage of its volume electronically, while the rival N#./#0 is completely electronic. The electronic markets use vast computer networks to match buyers and sellers, rather than human brokers. 3hile this system lacks the romantic and e*citing images of the N .- floor, it is efficient and fast. &any large institutional traders, such as pension funds, mutual funds, and so forth, prefer this method of trading. 8or the individual investor, you fre%uently can get almost instant confirmations on your trades, if that is important to you. )t also facilitates further control of online investing by putting you one step closer to the market. ou still need a broker to handle your trades 9 individuals don(t have access to the electronic markets. our broker accesses the e*change network and the system finds a buyer or seller depending on your order.

3hat does this all mean to you: )f the system works, and it does most of the time, all of this will be hidden from you, however if something goes wrong it(s important to have an idea of what(s going on behind the scenes.

Investing and Taxes

Ta*es are a part of our lives and there is no getting around that fact. That said, there is no legal or moral reason for you to pay any more than you are legally re%uired to pay. 3ith some planning and fore knowledge, you can keep your ta* bill for your stock investing to a minimum. This is not an article on ta* dodging or evasion, nor is it a substitute for competent ta* counsel for comple* ta* issues. ) have an agreement with my ta* attorney friends 9 ) don(t practice ta* law and they don(t sue me. .o far, it(s working out pretty well.

There are two main ways income or profits from investing in stocks may be ta*ed+

'apital gains ta* /ividend income ta*

;oth of these ta*es may come into play and here is when and how they are different+

Capital Gains Tax

# capital gain occurs when you sell an asset for a profit. That asset could be a house, land, machinery, stock, or a bond. 3hen that happens, the capital gains ta* comes into play. .ince we are discussing stocks, )(ll stick with how the ta* applies to investing. ou figure the capital gains ta* on the difference between your basis in the stock and the sales price. This difference is your profit or loss. The basis is usually what you paid for the stock, however if you inherit the stock, the basis is the price of the stock on the day the owner died. )f the difference between the basis and the sales price is negative, in other words, you lost money< you have a capital loss, which you can use to offset capital gains. There are two types of capital gains+

=ong4term 'apital >ains .hort4term 'apital >ains

?nderstanding the difference is very important.

Long-term Capital Gains

ou must hold the stock at least one full year to %ualify for the long4term capital gains rates. This is e*tremely important and ) encourage you to make absolutely sure by holding the stock one4year and a day at least. The ta* on a long4term capital gain is currently !@A if you are in the 5@A income ta* bracket or higher and just @A if you are in the !@A or lower ta* bracket. #s you will see, %ualifying for the long4term rates is important.

Short-term Capital Gains

)f you hold a stock less than one year before selling it, the )B. classifies the sale as a short4term capital gain and ta*es the profit as ordinary income. This means you could pay 5@A or much higher of your profit in ta*es.

?nless there is a compelling reason, hold on to the stock long enough to %ualify for the long4term capital gains rates.

i!idend Tax
'ompanies that distribute profits through dividends create a ta*able event for you. The )B. ta*es dividends at !@A, but this is a ta*4relief provision that could e*pire after 5"!! if not renewed. ,therwise, dividends may be considered ordinary income and ta*ed at your current rate. There is not much you can do to avoid some ta* on dividends, unless you hold your stock in a %ualified retirement plan and have a dividend reinvestment plan.

Tax "lanning
)f you have made sure all of your capital gains %ualify as long term, your ne*t possibility is to look at any losing stocks you may want to dump. ou can take a capital loss in the same year you have a gain and offset it. This is one of the reasons the stock market some times dips toward the end of the year as investors dump losing positions to offset gains. However, don(t sell a stock just for ta* reasons. )f there is good reasons to e*pect the stock will rebound, it doesn(t make much sense to sell it.

#ash $ule
The )B. has a rule in place to prevent investors from selling a stock in a losing position to offset a gain, only to turn around and buy the stock right back. )t is called the wash rule and it says you can(t sell a stock and buy it back within 6" days and claim a capital loss. )f you sell a stock and buy it back within 6" days, the )B. will disallow the capital loss and you will lose the offset.

)f you are careful you can keep the ta* bite to a minimum, however always seek competent ta* counsel with %uestions about comple* ta* %uestions.