Wash Trading

What does 'Wash Trading' mean

Wash trading refers to buying shares through one broker and selling the shares through another broker. Wash trading is not legal, as it is performed to manipulate the market and encourage other investors to move into a buying position. A quick turnaround of positions is not considered wash trading, provided the transaction creates market risk for the trader and alters his market position.

BREAKING DOWN 'Wash Trading'

Also known as round trip trading, the act of wash trading allows traders to buy stocks and then sell them, giving the appearance of purchases and sales being made, but the trader does not incur any market risk or change in market position.

The Commodity Exchange Act

The Commodity Exchange Act (CEA) establishes regulations for the trading of commodity futures in the United States. Under the CEA, wash trading is illegal. The CEA was passed in 1936 and has been amended a number of times since its establishment. It replaced the Grain Futures Act of 1922. This Act provides the statutory framework under which the Commodity Futures Trading Commission (CFTC) operates. The CFTC was created in 1974 as a result of the CEA.

Wash Sale

A wash sale is completely separate from wash trading. A wash sale is the sale of a security, such as stocks or bonds, at a loss. The same, or nearly the same, security is then repurchased quickly, within 30 days, either before or after the sale. Wash sales are used as collateral for margin debt; they must be approved by the Federal Reserve Bank. In addition to a trader buying back the same security within the 30-day period, a wash sale is also approved if the trader acquires an identical security in a taxable trade or acquires an option or contract to buy the same security that was sold.

Regulations surrounding wash sales are designed to protect an investor who carries an underlying loss and then wants to claim it as a tax deduction in the current tax year. The security is repurchased with the intention of recovering its previous value, with taxation happening in a future year. In certain tax codes within the United States, tax regulations are in place to prevent the practice of wash sales. Under wash sale rules, the disallowed loss is added to the basis of the repurchased security, the loss on the sale cannot be claimed on taxes and the holding period on the repurchased stock is inclusive of the holding period on the stock that was sold.