Table of Contents
Wash trading is an illegal practice in which an investor buys and sells the same or a nearly identical stock or security within a certain period of time. Wash trading is a prohibited activity under the Commodity Exchange Act (CEA) of 1936 and the Securities Exchange Act of 1934.
Wash trading is basically an attempt at market manipulation and a way to portray false market activity. Read on to learn about the implications of wash trading and how it works.
Key Points
• Wash trading is a prohibited practice in which investors engage in buying and selling the same or similar securities to create the illusion of trading activity.
• This practice can be a form of market manipulation and a way to portray false market activity.
• The goal of wash trading is often to influence pricing or trading activity.
• Wash trading is illegal and may result in penalties from regulatory agencies.
• A wash sale is different from wash trading. The wash sale rule prohibits an investor from taking a tax deduction on a loss when they purchase the same or substantially identical security within 30 days before or after the sale.
What Is Wash Trading?
Wash trading occurs when an investor buys and sells the same or a similar security investment around the same time. This is also called round-trip trading, since an investor is essentially ending where they began — with shares of the same security in their portfolio.
Wash trades can be used as a form of market manipulation. Investors may buy and sell the same securities in an attempt to influence pricing or trading activity. The goal may be to spur buying activity to send prices up or encourage selling to drive prices down.
Some investors and brokers might work together to influence trading volume, usually for the financial benefit of both sides. The broker, for example, might benefit from collecting commissions from other investors who want to purchase a stock being targeted for wash trading. The investor, on the other hand, may realize gains from the sale of securities through price manipulation.
Wash trading is different from insider trading, which requires the parties involved to have some special knowledge about a security that the general public doesn’t. However, if an investor or broker possesses insider knowledge they could potentially use it to complete wash trades.
How Does Wash Trading Work?
Essentially, a wash trade means an investor is buying and selling shares of the same security at around the same time. But the definition of wash trades goes further and takes the investor’s intent (and that of any broker they may be working with) into account. There are generally two conditions that must be met for a wash trade to exist:
• Intent. The intent of the parties involved in a wash trade (i.e., the broker or the investor) must be that at least one individual involved in the transaction must have entered into it specifically for that purpose.
• Result. The result of the transaction must be a wash trade, meaning the same asset was bought and sold at the same time or within a relatively short time span for accounts with the same or common beneficial ownership.
Beneficial ownership means accounts that are owned by the same individual or entity. Trades made between accounts with common beneficial ownership may draw the eye of financial regulators, as they can suggest wash trading activity is at work.
Wash trades don’t necessarily have to involve actual trades, however. They can also happen if investors and traders appear to make a trade on paper without any assets changing hands.
đź’ˇ Quick Tip: Before opening an investment account, know your investment objectives, time horizon, and risk tolerance. These fundamentals will help keep your strategy on track and with the aim of meeting your goals.
Example of a Wash Trade
Here’s a wash trade example:
Say an investor owns 100 shares of a stock and sells those shares at a $5,000 loss on September 1. On September 5, they purchase 100 shares of the same stock, then resell them for a $10,000 gain. This could be considered a wash trade if the investor engaged in the trading activity with the intent to manipulate the market.
Is Wash Trading Illegal?
Yes, wash trading is illegal. The Commodity Exchange Act prohibits wash trading. Prior to the passage of the Act, traders used wash trading to manipulate markets and stock prices. The Commodity Futures Trade Commission (CFTC) also enforces regulations regarding wash trading, including guidelines that bar brokers from profiting from wash trade activity.
It’s important to distinguish between wash trading and a wash sale, which is an IRS rule. The IRS wash sale rule does not allow investors to deduct capital losses on their taxes from sales or trades of stocks or other securities in particular circumstances.
Under the IRS rules, a wash sale occurs when an investor sells or trades stocks at a loss and within 30 days before or after the sale they:
• Purchase substantially identical stock or securities
• Acquire substantially identical stock or securities in a fully taxable trade
• Acquire a contract or option to buy substantially identical stock or securities, or
• Acquire substantially identical stock for your individual retirement arrangement (IRA) or Roth IRA
Wash sale rules also apply if an investor sells stock and their spouse or a corporation they control buys substantially identical stock. When a wash sale occurs, an investor is not able to claim a tax deduction for those losses.
Essentially, the IRS wash sale rule is a tax rule. Wash trading is a form of intentional market manipulation.
Difference Between Wash Trading & Market Making
Market making and wash trading are not the same thing. A market maker is a firm or individual that buys or sells securities at publicly quoted prices on-demand, and a market maker provides liquidity and facilitates trades between buyers and sellers. For example, if you’re trading through an online broker you’re using a market maker to complete the sale or purchase of securities.
Market making is not market manipulation. A market maker is, effectively, a middleman between investors and the markets. While they do profit from their role by maintaining spreads on the stocks they cover, this is secondary to fulfilling their purpose of keeping shares and capital moving.
Recommended: What Is a Brokerage Account?
How to Detect & Avoid Wash Trading
The simplest way to avoid wash trading as an investor is to be aware of what constitutes a wash trade. Again, this can mean the intent to manipulate the markets by placing similar trades within a short timeframe.
Investors may notice red flags that may signal wash trading, such as multiple trades that have identical quantities and prices, repeated buying and selling between certain traders, and unusual trading patterns or volumes. Financial institutions and regulators also monitor trading data to identify or help prevent manipulative or abusive trading.
To avoid a wash sale, conversely, an investor could be mindful of the securities they are buying and selling and the timeframe in which those transactions are completed. So selling XYZ stock at a loss, then buying it again 10 days later to sell it for a profit would likely constitute a wash sale if they executed the trade and attempted to deduct the initial loss on their taxes.
It’s also important to understand how the 30-day period works. The 30-day rule extends to the 30 days prior to the sale and 30 days after the sale. So effectively, an investor could avoid the wash sale rule by waiting 61 days to replace assets that they sold in their portfolio.
đź’ˇ Quick Tip: How to manage potential risk factors in a self-directed investment account? Doing your research and employing strategies like dollar-cost averaging and diversification may help mitigate financial risk when trading stocks.
The Takeaway
Wash trading involves selling certain securities and then replacing them in a portfolio with identical or very similar securities within a certain time period. This is typically done with the intent to manipulate the market. Wash trading is illegal.
Wash trading is not to be confused with the wash sale rule. For investors, understanding when the IRS wash sale rule applies can help them comply with tax guidelines. Those who are unclear about it, may wish to consult with a financial or tax professional.
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FAQ
What’s considered wash trading
Wash trading is an illegal practice in which an investor buys and sells the same or a nearly identical security with the intent of falsely implying increased trading activity. It’s a form of market manipulation that could deceive other investors into making trades.
What’s the difference between wash trading and the wash sale rule?
Wash trading is an illegal practice with an intent to manipulate the market. The wash sales rule is a tax rule that says an investor cannot sell stock or securities for a loss and then buy substantially identical shares within 30 days before or after the sale and claim the deduction of the sale on their taxes.
Is a wash sale illegal?
No, a wash sale is not illegal. A wash sale is a tax rule that does not allow investors to claim a tax deduction if they sold a stock for a loss and then bought a substantially similar stock or security within 30 days before or after the sale.
How do day traders avoid wash sales?
To properly follow the IRS wash sales rule, an investor can wait for more than 30 days before or after the sale of a stock or security for a loss — meaning for a total of 61 days — before purchasing one that’s identical or substantially identical and then claiming the deduction for the sale on their taxes.
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