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From: [email protected] (Christopher Lott)
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Subject: The Investment FAQ (part 16 of 20)
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Archive-name: investment-faq/general/part16
Version: $Id: part16,v 1.61 2003/03/17 02:44:30 lott Exp lott $
Compiler: Christopher Lott

The Investment FAQ is a collection of frequently asked questions and
answers about investments and personal finance. This is a plain-text
version of The Investment FAQ, part 16 of 20. The web site
always has the latest version, including in-line links. Please browse
http://invest-faq.com/

Terms of Use

The following terms and conditions apply to the plain-text version of
The Investment FAQ that is posted regularly to various newsgroups.
Different terms and conditions apply to documents on The Investment
FAQ web site.

The Investment FAQ is copyright 2003 by Christopher Lott, and is
protected by copyright as a collective work and/or compilation,
pursuant to U.S. copyright laws, international conventions, and other
copyright laws. The contents of The Investment FAQ are intended for
personal use, not for sale or other commercial redistribution.
The plain-text version of The Investment FAQ may be copied, stored,
made available on web sites, or distributed on electronic media
provided the following conditions are met:
+ The URL of The Investment FAQ home page is displayed prominently.
+ No fees or compensation are charged for this information,
excluding charges for the media used to distribute it.
+ No advertisements appear on the same web page as this material.
+ Proper attribution is given to the authors of individual articles.
+ This copyright notice is included intact.

Disclaimers

Neither the compiler of nor contributors to The Investment FAQ make
any express or implied warranties (including, without limitation, any
warranty of merchantability or fitness for a particular purpose or
use) regarding the information supplied. The Investment FAQ is
provided to the user "as is". Neither the compiler nor contributors
warrant that The Investment FAQ will be error free. Neither the
compiler nor contributors will be liable to any user or anyone else
for any inaccuracy, error or omission, regardless of cause, in The
Investment FAQ or for any damages (whether direct or indirect,
consequential, punitive or exemplary) resulting therefrom.

Rules, regulations, laws, conditions, rates, and such information
discussed in this FAQ all change quite rapidly. Information given
here was current at the time of writing but is almost guaranteed to be
out of date by the time you read it. Mention of a product does not
constitute an endorsement. Answers to questions sometimes rely on
information given in other answers. Readers outside the USA can reach
US-800 telephone numbers, for a charge, using a service such as MCI's
Call USA. All prices are listed in US dollars unless otherwise
specified.

Please send comments and new submissions to the compiler.

--------------------Check http://invest-faq.com/ for updates------------------

Subject: Tax Code - Non-Resident Aliens and US Holdings

Last-Revised: 26 Jan 2003
Contributed-By: Vladimir Menkov (vmenkov at cs.indiana.edu), Chris Lott
( contact me ), Enzo Michelangeli (em at who.net)

Non-resident aliens can hold investments in the United States quite
easily. A "non-resident alien" (NRA) is the U.S. government's name for
a citizen of a country other than the U.S. who also lives outside the
U.S. The only thing non-resident aliens have to be concerned about if
they have U.S. investments is taxation.

For example, if a non-U.S. national works in the U.S. for some period
of time and amasses a nice portfolio of stocks while here, that person
can hang on to the portfolio forever, no matter whether they continue to
live in the U.S. or not. But they will have to continue to deal with
the U.S. tax authority, the IRS.

Thanks to the U.S. Congress, the tax laws are complicated, and a
resident or nonresident alien must look carefully to find a tax advisor
who understands all the issues. Here's an overview.

A person is considered non-resident in the years when that person is in
the US fewer than 183 days; the actual rule is a little more complex,
and takes prior years into account; see IRS publication 519 for details.
Anyhow, in the years when a non-US citizen is considered a non-resident
for tax purposes, that person files the US tax return on form 1040 NR,
instead of regular 1040 (EZ, A), and pays tax on investment income
according to the following special rules.

* No tax on capital gains. This means that a brokerage or a mutual
fund should withhold nothing when selling shares. With respect to
mutual funds, long-term capital gain distributions are exempt as
well.
* No tax on bank interest. This means regular accounts with credit
unions, savings and loans, etc.
* No tax on portfolio interest. (It's not always easy to figure out
interest on what bonds qualifies as "portfolio interest", though.
Some readers have reported that brokerage firms are confused on
this issue, unfortunately.)
* 30% flat-rate tax on dividends. Generally this includes dividend
and short-term cap gain distributions by mutual funds. This rate
may be reduced by a tax treaty with your country of residence.
(Progressive taxation does not apply to NRAs; i.e., the first and
last dollars are taxed at the same rate.)
* 30% flat-rate tax on interest that neither is paid by a bank nor
qualifies as "portfolio interest." This rate may be reduced by a
tax treaty with the person's country of residence.
* No personal exemption or deductions can be applied against
investment income (which is, technically, "income not effectively
connected with your US trade or business"). Further, according to
the IRS, "if your sole U.S. business activity is trading
securities through a U.S. resident broker or other agent, you are
not engaged in a trade or business in the United States" so the
income is not effectively connected with a US trade or business.
* If the alien is a non-resident for the tax purposes in a given
year, but spends 183 days or more in the country, any capital gains
are also subject to the 30% flat tax. This is a fairly rare but
possible situation.

The issue of an investment paying dividends versus paying interest is
simple in case of stocks (dividends) and basic savings accounts
(interest), but what about money market accounts? Well, money-market
mutual funds pay dividends , while money-market bank accounts pay
interest , for the purposes of 1040 NR. However, if you have a money
market fund with a bank and the bank reports the income as dividends, it
is probably simplest to report the income exactly as the institution
reported it rather than try to fight it. I don't know why this isn't
straightforward, but for some reason it is not. For more information,
see IRS Publication 550, "Investment Income and Expenses." In the 2000
edition, the relevant language appears in the first column of page 5, in
the section "Interest Income," subsection "Taxable Interest - General."

Tax treaties are very important. If the individual's country of
residence has an agreement (tax treaty) with the US government, those
rules pretty much supersede the standard rules set by the Internal
Revenue Code. In particular, they often reduce the tax rate on interest
and dividend income.

While you are a non-resident alien, you are supposed to file Form W-8BEN
(it replaces older Forms W-8 and 1001) with each of your mutual funds or
brokers every 3 or 4 years, so that they will automatically withhold tax
from your investment income. Since you have to indicate your country of
residence for tax purposes on this form, the investment income payor
will know what tax treaty, if any, applies. In the spring, the payor
will send you a form 1042-S reporting your income, its type, and the tax
withheld.

If Forms W-8BEN have been filed and the appropriate tax has been
withheld, you won't need to send any money to the IRS with your 1040 NR
in April; in fact, you won't even need to file 1040 NR at all if you
don't have other US-source income. Note also that as a non-resident you
will not be eligible to claim standard deduction, or to claim married
status, or file form 1116 (foreign tax credit).

The IRS enacted some rules in late 2000 to establish "Qualified
Intermediary" status for foreign financial institutions. The rules did
not change tax liabilities, just made it more difficult for a person to
escape paying tax. To summarize, a financial institution must withhold
money from payments of US-source income to individuals outside the US
unless the institution qualifies for the newly introduced status of
"qualified intermediary", or unless the institution agrees to disclose
the list of all beneficiaries to the IRS. A financial institution is
eligible to apply for qualified intermediary status if it is in a
country that has been approved by the IRS as having acceptable
'know-your-customer' rules.

None of this discussion applies to resident aliens or to US citizens
living abroad. Once you are considered a bona fide resident of the
U.S., the tax rules that apply to U.S. citizens also apply to you.

Here are some IRS resources that offer all the details:
* IRS Publication 515, "Withholding of Tax on Non-Resident Aliens"
http://www.irs.gov/forms_pubs/pubs/p515toc.htm
* IRS Publication 519, "U.S. Tax Guide for Aliens"
http://www.irs.gov/forms_pubs/pubs/p519toc.htm
* IRS Publication 901, "Tax Treaties"
http://www.irs.gov/forms_pubs/pubs/p901toc.htm
* IRS Tax Topic 851, "Resident and Nonresident Aliens"
http://www.irs.ustreas.gov/prod/tax_edu/teletax/tc851.html
* The IRS web site "Digital Daily" has a collection of information
for the International Taxpayer.
http://www.irs.gov/businesses/small/international/
* The Digital Daily's area includes this article which focuses on the
taxation of capital gains Of nonresident aliens (the link is
unfortunately buried in another article).
http://www.irs.gov/businesses/small/international/article/0,,id=96400,00.html

--------------------Check http://invest-faq.com/ for updates------------------

Subject: Tax Code - Reporting Option Trades

Last-Revised: 16 Aug 2000
Contributed-By: Michael Beyranevand (mlb2 at bryant.edu)

This article summarizes the rules for reporting gains and losses from
trading stock options. Like any other security transaction, even if you
get cash up front as in the case of shorting a stock or writing an
option, you do not declare a profit or loss until the transaction has
been closed out. Also note that ordinary options expire in 6 months or
less, so most gains or losses are short-term (but see below for an
exception in the case of writing covered calls). However, LEAPS can
have a lifetime of over 2 years (also see the article elsewhere in this
FAQ ), so gains or losses might be long-term for the purpose of the tax
code.

Buyers of Options
There are three different tax treatments that could occur when you
decide to buy a put or call option. The first is that you reverse
your position (sell the option) before the exercise date. If this
is the case, then you will have either a short-term (if held for
under 1 year) or long-term (if held for more than 1 year) capital
gain/loss to report.

The second tax treatment occurs if you allow the option to expire
unexercised. It would then be treated as either a short-term or
long-term loss based on the holding period of the option at the
expiration date.

The third tax treatment for buying options occurs when you decide
to exercise either your put or call option. If you exercise your
call (the right to buy stock) you add the cost of the call to the
cost basis of your stock. If you exercise a put (the right to sell
stock) then the cost of the put reduces your total amount realized
when figuring gain or loss on the sale of that stock.

Sellers of Options
There are also three tax treatments that could occur when you sell
a put or call option. The first possibility is that you reverse
your position on an option that you wrote. Then it would become
either be a short-term gain or loss. The difference between what
you sold it and bought it back at will determine the gain/loss
status.

The second possibility is that the option expires (it is not
exercised before the expiration date). In this scenario you would
report the premium received as a short-term capital gain in the
year the option expires.

The third situation is when the option is exercised (you are called
or put). In the case of a call, you add the premium to the sale
proceeds of the stock to determine a gain or loss on the sale of
the stock. The holding period of the stock (not the option!) will
determine if the gain is short term or long term. So if it was a
covered call, it might be short or long term. If it was a naked
call, the holding period will be brief (minutes?) and so it's a
short-term gain. In the case of a put that is exercised, the tax
situation is significantly more complex as compared to a call. To
determine if the premuim counts as income when the put is exercised
or if it just lowers the cost basis of the stock is determined by
many factors, just one of which is whether the put was in the money
or out of the money when it was written, and to what extent.
Novice put writers should consult with a professional tax advisor
for assistance.

For the last word on the tax implications of trading options, get IRS
Publication 550, _Investment Income and Expenses_.

--------------------Check http://invest-faq.com/ for updates------------------

Subject: Tax Code - Short Sales Treatment

Last-Revised: 13 Aug 1999
Contributed-By: Art Kamlet (artkamlet at aol.com), Chris Lott ( contact
me )

Gains from a short-sale stock transaction are considered short-term
capital gains regardless of how long the position is held open. This
actually makes a kind of sense, since the only time you actually held
the stock was between when you bought the stock to cover the position
and when you actually delivered that stock to actually close the
position out. This length of time is somewhere from minutes to a few
days. (Please see articles elsewhere in this FAQ explaining short
sales, as well as long- and short-term capital gains.)

What do you do if a short sale is open at the end of a calendar year?
Brokerage houses report all sales (normal or short) on Form 1099-B as
"sales", so you might think that you have to report it on your Schedule
D to make the total sales number equal that reported to the IRS. But
since the position is still open, the sale was not a taxable event. You
sure don't want to pay tax on the amount of money you received when you
went short!

Here's one way to proceed. You can attach a statement along the
following lines to your Schedule D:

Attachment to 1998 Form 1040 Schedule D (Names & Social
security #)

Explanation of the difference between Forms 1099-B and
Schedule D Sales totals:

Forms 1099-B include $XXXX of short sales which were opened in
1998 and remained open on 31 December 1998.

Forms 1099-B Totals: $YYYY
less short positions
opened during 1998
remnaining open 12/31/98 ( $XXXX )
_______
Adjustment (if any) $WWWW
________
Schedule D Sales Totals $ZZZZ

Note that when the short positions are finally closed out, the brokerage
house will not make any indication on that year's 1099-B, but that's the
year when you have to report the gains or losses realized in the
transaction.

--------------------Check http://invest-faq.com/ for updates------------------

Subject: Tax Code - Tax Swaps

Last-Revised: 12 Aug 1996
Contributed-By: Bill Rini (bill at moneypages.com), and other anonymous
contributors

A tax swap is an investment strategy usually designed for municipal bond
portfolios. It is designed to allow you to take a tax loss in your
portfolio while at the same time adjusting factors such as credit
quality, maturity, etc. to better meet your current needs and the
outlook of the market. A tax swap can create a capital loss for tax
purposes, can maintain or enhance the overall credit quality of your
portfolio, and can increase current income.

It's important to note that tax swaps are not for everyone. And as
always, you should consult with a tax professional before making any
investment desicion that is designed to produce tax benefits.

Here is an example of a hypothetical tax swap. I have not factored
accrued interest to keep the calculations fairly simple.

Current Bond - You will sell this bond to generate a capital loss.

$10,000 par value "ABC" Tax Free bond, A rated, with a coupon of 4.70%.
maturing 09/01/03 originally purchased for $10,000 (100) but with a
current market value of only $9030 (90.30).

Replacement Bond - The bond you will buy to replace your current bond.

$10,000 par value "XYZ" Tax Free bond, AAA rated, with a coupon of 5.20%
maturing 12/01/12 The current selling price of this bond is $8724
(87.24)
Sell "ABC" Bond $9030.00
Buy "XYZ" Bond $8724.00
--------
Difference: $306.00
The tax swap accomplished the following. First, you received $306.00
cash. Second, you upgraded the credit quality of your single-bond
portfolio from A to AAA. Third, you generated a capital loss of $970.00
(original purchase price minus the selling price). Fourth, you've
increased the bond's maturity and coupon, so its duration will be
greater. This swap will increase the portfolio's sensitivity to
interest rate changes, which may or may not be what the investor had in
mind. In particular, it might be not appropriate for a short-term
investment. If the bond is held to maturity, then no risk is assumed
other than default risk. (Although unrealized value would change
wildly, and perhaps that's taxable in some circumstance).

Portions of this article are copyright 1995 by Bill Rini.

--------------------Check http://invest-faq.com/ for updates------------------

Subject: Tax Code - Uniform Gifts to Minors Act (UGMA)

Last-Revised: 15 Feb 2001
Contributed-By: Art Kamlet (artkamlet at aol.com), Aaron Schindler, Mark
Eckenwiler, Brian Mork, Rich Carreiro (rlcarr at
animato.arlington.ma.us)

The Uniform Gifts to Minors Act (UGMA), called the Uniform Transfers to
Minors Act (UTMA) in some states, is simply a way for a minor to own
securities.

The UGMA/UTMA setup is commonly used to give monies to a minor. IRS
regulations allows a person to give many thousands of dollars per year
to any other person with no tax consequences (please see the FAQ article
on Estate and Gift Tax for current numbers). If the recipient is a
minor, the UGMA provides a way for the minor to own the assets without
involving an attorney to establish a special trust. When giving assets
to a minor using a UGMA/UTMA, the donor must appoint a custodian (the
trustee).

An UGMA/UTMA is a trust like any other trust except that the terms of
the trust are set in the state statute instead of being drawn up in a
trust document. Should a trustee fail to comply with the terms of the
UGMA/UTMA, this would expose the trustee to the same actions as a
trustee who fails to comply with the terms of a special drawn-up trust.

Why is a UGMA useful? The UGMA/UTMA offers a straightforward way for a
minor to own securities. In most (all?) states, minors do not have the
right to contract. So a minor could not be bound by any broker's
account agreement. If a broker took a minor's account, the minor, upon
reaching majority, could repudiate any losing trades and make the broker
eat them. Thus brokers and fund companies once refused to take minor's
accounts. UGMA/UTMA was basically a way of providing a form of
ownership that got around this problem, without forcing people to go
through the expense of having an attorney draw up a special trust.

To establish a UGMA/UTMA account, go to your friendly neighborhood
stockbroker, bank, mutual fund manager, or (close your eyes now: S&L),
etc. and say that you wish to open a Uniform Gifts (in some states
"Transfers") to Minors Act account.

You register it as:

[ Name of Custodian ] as custodian for [ Name of Minor ] under
the Uniform Gifts/Transfers to Minors Act - [ Name of State of
Minor's residence ]

You use the minor's social security number as the taxpayer ID for this
account. When you fill out the W-9 form for this account, it will show
this form. The custodian should certify the W-9 form.

The money now belongs to the minor and the custodian has a legal
fiduciary responsibility to handle the money in a prudent manner for the
benefit of the minor.

Handling the money "in a prudent manner" means that the custodian can
buy common stocks but cannot write naked options. The custodian cannot
"invest" the money on the horses, planning to donate the winnings to the
minor. And when the minor reaches the age at which the UGMA becomes
property of the minor (who is either 18 or 21 depending on the state and
not a minor any loger), the minor can claim all of the funds even if
that's against the custodian's wishes. Neither the donor nor the
custodian can place any conditions on those funds once the minor becomes
an adult.

You may be concerned about preventing a minor from blowing the college
fund on a Trans Am the moment the minor attains the turnover age and the
money is under their control. Legally there is nothing the custodian
(or anyone else) can do. Some may sugggest that a UGMA account can be
hidden from a minor, but this is a problem for two reasons. First, any
minor over age 14 is expected to sign his or her tax return and thus has
a good chance to notice the income from the account. Second and more
seriously, if the custodian fails to turn over money that is due to the
UGMA beneficiary, he or she breaches the statutory trust terms and is
liable for the consequences of that failure, just as any other trustee
would be, which may include surcharges and other sanctions from a court.

If it is any consolation, some states allow the donor to establish a
"turnover" age of 21 (instead of the default 18) by making an express
statement to that effect when the account is created. In other states,
the turnover age is 21 by default, and an express statement is required
to establish a lower turnover age.

The trustee can transfer funds between UGMA/UTMA accounts at will. For
example, this might be attractive if a UGMA seems to be underperforming
similar type accounts or if it lacks the services of other UGMA accounts
such as online access. The custodian is managing the funds on behalf of
the minor, and part of management is deciding where to place the funds
and with which bank, broker, or other fiduciary. The custodian must be
certain to maintain a paper trail showing that every dollar withdrawn
from one account was transferred to another account. If the UGMA
account is with a broker or mutual fund manager, and a transfer is
desired, contact the new broker or manager and they will arrange all the
paperwork for a direct transfer.

Given all the warnings above, there is a way to give money to a minor
and restrict the minor's access until you feel he or she is ready. The
mechanism is not a UGMA, however, but another sort of trust. Contact
American Century Investments for information about their GiftTrust fund.
The fund is entirely composed of trusts like this. The trust pays its
own taxes. Unfortunately, this company may not keep the trust as quiet
as you would like. When opening a Gift Trust, confirmation is sent to
the donor, but in their words, "Subsequent confirmations are sent to the
beneficiary's address." Further, they insist that Form 709 must be
filed, it's a future interest and does not qualify for 10,000 exclusion;
taxes must be paid now or consume part of lifetime $600,000 exemption.

A future interest is just what it says: an interest in something that a
person does not own until some time in the future. The American Century
GiftTrust is an example of that. I believe the terms of the account
state that money cannot be taken out of the account for any reason
(except death of beneficiary) until the account has been open for at
least 10 years. So the beneficiary does not actually truly own the
assets until some time in the future. However, in certain situations,
the *dis*qualified exemption of a future interest doesn't apply. In
other words a Form 709 is *sometimes* not necessary and the lifetime
$600K (which is crawling upwards these days) isn't dented. The IRS regs
list these disqualifications of the disqualifications (don't you just
love tax law?).

In contrast, a minor is considered to own (though he or she does not
control) the assets of an UGMA/UTMA account from the second assets are
placed into the account -- the assets can be used for his or her benefit
immediately. Therefore, gifts to an UGMA/UTMA are gifts of a present
interest and do qualify for the $10,000 annual gift exclusion.

With respect to gifts of a future interest (that are not eligible for
the $10K annual exclusion) or for gifts that are eligible but are over
$10K, a donor does not have the choice between paying gift tax and using
up some of his or her unified credit. The donor is required to use
unified credit first, only paying the gift tax once the unified credit
is exhausted. See the article elsewhere in this FAQ on estate and gift
taxes for more information.

Note that if the trustee acts in such a way as to give the IRS cause to
believe that no true gift was ever actually made, the IRS takes the
position that no gift was made and taxes all the income to the parent
instead of to the minor. But this is not unique to UGMA/UTMA.

On a related note, some accountants advise that one person should make
the gift and that a different person should be the custodian. The
reason is that if the donor and custodian are the same person, that
person is considered to exercise sufficient control over the assets to
warrant inclusion of the UGMA in his/her estate. For more info, see
Lober, Louis v. US, 346 US 335 (1953) (53-2 USTC par. 10922); Rev Ruls
57-366, 59-357, 70-348.

All of these are cited in the RIA Federal Tax Coordinator 2d, volume
22A, paragraph R-2619, which says (among other things) "Giving cash,
stocks, bonds, notes, etc., to children through a custodian may result
in the transferred property being included in the donor's gross estate
unless someone other than the donor is named as custodian."

Finally, a word about taxes. Income that accrues to a minor, such as
income from a UGMA account, is taxed as follows in tax year 2000.
Assuming the child has no other income and is under age 14, the first
$700 of investment income falls into the child's zero bracket. The next
$700 is taxed at 15%, and the rest is taxed at the parents' top bracket
(The expected numbers for tax year 2001 are both $750.) The tax on a
child's income imposed at the parents' top bracket is the so-called
"kiddie tax." If the child is 14 or over, the parent's tax situation
does not come into play at all. All the income is on the child's return
and he or she is taxed as an entity unto himself/herself. Always check
the Form 1040 instructions for the appropriate number to use for a given
tax year. Also note that IRS regulations require all minors 14 or older
to sign their own tax returns. Finally, please note that these tax
rules are for earned and unearned income for a minor; there is no
special tax treatment for UGMA accounts.

--------------------Check http://invest-faq.com/ for updates------------------

Subject: Tax Code - Wash Sale Rule

Last-Revised: 11 Mar 2000
Contributed-by: Art Kamlet (artkamlet at aol.com), Rich Carreiro (rlcarr
at animato.arlington.ma.us)

A "wash sale" describes the situation in which you sell shares of some
security at a loss, and within 30 days you purchase substantially
identical securities. At face value, it looks like you took a loss on
an investment (would would be deductible from your gross income when you
do your taxes), yet you still own that investment, you just now have a
lower cost basis. Unfortunately, the IRS does not consider the loss
resulting from such a transaction to be deductible. If a sale is
considered to be a wash sale, the loss cannot be treated as a capital
loss on your federal tax return. In fact, the cost basis of the
securities purchased is increased by the amount of that disallowed loss.
The goal is to prevent someone from converting a paper loss into a real
loss while actually hanging onto that same position.

For the word from the horses mouth, here's a quote from IRS publication
550, "Investment Income and Expenses" (1990), p. 37:

Wash Sales:
You cannot deduct losses from wash sales or trades of stock or
securities. However, the gain from these sales is taxable.

A wash sale occurs when you sell stock or securities at a loss and
within 30 days before or after the sale you buy or acquire in a fully
taxable trade, or acquire a contract or option to buy, substantially
identical stock or securities. If you sell stock and your spouse or a
corporation you control buys substantially identical stock, you also
have a wash sale. You add the disallowed loss to the basis of the new
stock or security.

This rule includes normal purchases followed by sales (i.e., you go
long, then sell at a later date) as well as short sales and later
purchases.

Here's an extended example that may help clarify how the math must be
done. The rule is actually rather simple, but when lots of trades are
involved it can lead to very complicated situations.
1. 4/01/99 bought 100 at 120.
2. 5/01/99 sold 100 at 110
The loss was 10 x 100 = $1000.
3. 5/02/99 bought 100 at 95.
Causes a wash sale of loss on 5/01/99.
4. 5/03/99 sold 100 at 100.
The gain was 5 x 100 = $500, but you must add the wash sale $1000
into the basis of the purchase on 5/02/99, therefore this turns
into a loss of $500.
5. 5/10/99 bought 100 at (any price).
The sale on 5/03/99 is considered a wash sale even though it became
a loss by adding in a wash sale from a previous sale. Stated
differently, wash sales can create subsequent wash sales.

The IRS publication goes on explaining all those terms (substantially
identical, stock or security, ...). It runs on several pages, too much
to type in. You should definitely call IRS for the most updated ones
for detail. Phone number: 800-TAX-FORM (800-829-3676). Or visit their
web site at http://www.irs.ustreas.gov

--------------------Check http://invest-faq.com/ for updates------------------

Subject: Technical Analysis - Basics

Last-Revised: 27 Jan 1998
Contributed-By: Maurice Suhre, Neil Johnson

The following material introduces technical analysis and is intended to
be educational. If you are intrigued, do your own reading. The answers
are brief and cannot possibly do justice to the topics. The references
provide a substantial amount of information.

First, the references; the links point to Amazon, where you can buy the
books if you're really interested.

1. John J. Murphy
Technical Analysis of the Futures Markets
2. Martin J. Pring
Technical Analysis Explained
3. Stan Weinstein
Stan Weinstein's Secrets for Profiting in Bull and Bear Markets

Now we'll introduce technical analysis and explain some commonly
mentioned aspects.

1. What is technical analysis?
Technical analysis attempts to use past stock price and volume
information to predict future price movements. Note the emphasis.
It also attempts to time the markets.

2. Does it have any chance of working, or is it just like reading tea
leaves?
There are a couple of plausibility arguments. One is that the
chart patterns represent the past behavior of the pool of
investors. Since that pool doesn't change rapidly, one might
expect to see similar chart patterns in the future. Another
argument is that the chart patterns display the action inherent in
an auction market. Since not everyone reacts to information
instantly, the chart can provide some predictive value. A third
argument is that the chart patterns appear over and over again.
Even if I don't know why they happen, I shouldn't trade or invest
against them. A fourth argument is that investors swing from
overly optimistic to excessively pessimistic and back again.
Technical analysis can provide some estimates of this situation.

A contrary view is that it is just coincidence and there is little,
if any, causality present. Or that even if there is some sort of
causality process going on, it isn't strong enough to trade off of.

A very contrary view: The past and future performance of a stock
may be correlated, but that does not mean or imply causality. So,
relying on technical analysis to buy/sell a stock is like relying
on the position of the stars in the atmosphere or the phases of the
moon to decide whether to buy or sell.

3. I am a fundamentalist. Should I know anything about technical
analysis?
Perhaps. You should consider delaying purchase of stocks whose
chart patterns look bad, no matter how good the fundamentals. The
market is telling you something is still awry. Another argument is
that the technicians won't be buying and they will not be helping
the stock move up. On the other hand (as the economists say), it
makes it easy for you to buy in front of them. And, of course, you
can ignore technical analysis viewpoints and rely solely on
fundamentals.

4. What are moving averages?
Observe that a period can be a day, a week, a month, or as little
as 1 minute. Stock and mutual fund charts normally are daily
postings or weekly postings. An N period (simple) moving average
is computed by summing the last N data points and dividing by N.
Moving averages are normally simple unless otherwise specified.

An exponential moving average is computed slightly differently.
Let X[i] be a series of data points. Then the Exponential Moving
Average (EMA) is computed by:
EMA[i] = (1 - sm) * EMA[i-1] + sm * X[i]

where sm = 2/(N+1), and EMA[1] = X[1].

"sm" is the smoothing constant for an N period EMA. Note that the
EMA provides more weighting to the recent data, less weighting to
the old data.

5. What is Stage Analysis?
Stan Weinstein [ref 3] developed a theory (based on his
observations) that stocks usually go through four stages in order.
Stage 1 is a time period where the stock fluctuates in a relatively
narrow range. Little or nothing seems to be happening and the
stock price will wander back and forth across the 200 day moving
average. This period is generally called "base building". Stage 2
is an advancing stage characterized by the stock rising above the
200 and 50 day moving averages. The stock may drop below the 50
day average and still be considered in Stage 2. Fundamentally,
Stage 2 is triggered by a perception of improved conditions with
the company. Stage 3 is a "peaking out" of the stock price action.
Typically the price will begin to cross the 200 day moving average,
and the average may begin to round over on the chart. This is the
time to take profits. Finally, the Stage 4 decline begins. The
stock price drops below the 50 and 200 day moving averages, and
continues down until a new Stage 1 begins. Take the pledge right
now: hold up your right hand and say "I will never purchase a stock
in Stage 4". One could have avoided the late 92-93 debacle in IBM
by standing aside as it worked its way through a Stage 4 decline.

6. What is a whipsaw?
This is where you purchase based on a moving average crossing (or
some other signal) and then the price moves in the other direction
giving a sell signal shortly thereafter, frequently with a loss.
Whipsaws can substantially increase your commissions for stocks and
excessive mutual fund switching may be prohibited by the fund
manager.

7. Why a 200 day moving average as opposed to 190 or 210?
Moving averages are chosen as a compromise between being too late
to catch much move after a change in trend, and getting whipsawed.
The shorter the moving average, the more fluctuations it has.
There are considerations regarding cyclic stock patterns and which
of those are filtered out by the moving average filter. A
discussion of filters is far beyond the scope of this FAQ. See
Hurst's book on stock transactions for some discussion.

8. Explain support and resistance levels, and how to use them.
Suppose a stock drops to a price, say 35, and rebounds. And that
this happens a few more times. Then 35 is considered a "support"
level. The concept is that there are buyers waiting to buy at that
price. Imagine someone who had planned to purchase and his broker
talked him out of it. After seeing the price rise, he swears he's
not going to let the stock get away from him again. Similarly, an
advance to a price, say 45, which is repeatedly followed by a
pullback to lower prices because a "resistance" level. The notion
is that there are buyers who purchased at 45 and have watched a
deterioration into a loss position. They are now waiting to get
out even. Or there are sellers who consider 45 overvalued and want
to take their profits.

One strategy is to attempt to purchase near support and take
profits near resistance. Another is to wait for an "upside
breakout" where the stock penetrates a previous resistance level.
Purchase on anticipation of a further move up. [See references for
more details.]

The support level (and subsequent support levels after rises) can
provide information for use in setting stops. See the "About
Stocks" section of the FAQ for more details.

9. What would cause these levels to be penetrated?
Abrupt changes in a company's prospects will be reacted to in the
stock market almost immediately. If the news is extreme enough,
the reaction will appear as a jump or gap in prices. More modest
changes will result, in general, in more modest changes in price.

10. What is an "upside breakout"?
If a stock has traded in a narrow range for some time (i.e. built
a base) and then advances above the resistance level, this is said
to be an "upside breakout". Breakouts are suspect if they do not
occur on high volume (compared to average daily volume). Some
traders use a "buy stop" which calls for purchase when a stock
rises above a certain price.

11. Is there a "downside breakout"?
Not by that name -- the opposite of upside breakout is called
"penetration of support" or "breakdown". Corresponding to "buy
stops," a trader can set a "sell stop" to exit a position on
breakdown.

12. Explain breadth measurements and how to use them.
A breadth measurement is something taken across a market. For
example, looking at the number of advancing stocks compared to
declining stocks on the NYSE is a breadth measurement. Or looking
at the number of stocks above their 200 day moving average. Or
looking at the percentage of stocks in Stage 1 and 2
configurations. In general, a technically healthy market should
see a lot of stocks advancing, not just the Dow 30. If the breadth
measurements are poor in an advancing sense and the market has been
advancing for some time, then this can indicate a market turning
point (assuming that the advancing breadth is declining) and you
should consider taking profits, not entering new long positions,
and/or tightening stops. (See the divergence discussion.)

13. What is a divergence? What is the significance?
In general, a divergence is said to occur when two readings are not
moving generally together when they would be expected to. For
example, if the DJIA moves up a lot but the S&P 500 moves very
little or even declines, a divergence is created. Divergences can
signify turning points in the market. At a major market low, the
"blue chip" stocks tend to move up first as investors becoming
willing to purchase quality. Hence the S&P 500 may be advancing
while the NYSE composite is moving very little. Divergences, like
everything else, are not 100 per cent reliable. But they do
provide yellow or red alerts. And the bigger the divergence, the
stronger the signal. Divergence and breadth are related concepts.
(See the breadth discussion.)

14. How much are charting services and what ones are available?
Commercial services aren't cheap. Daily Graphs (weekly charts with
daily prices) is $465 for the NYSE edition, $432 for the AMEX/OTC
edition. Somewhat cheaper for biweekly or monthly. Mansfield
charts are weekly with weekly prices. Mansfield shows about 2.5
years of action, Daily Graphs shows 1 year or 6 months for the less
active stocks. Of course there are many charts on the web. See
the article elsewhere in the technical analysis section of this FAQ
about free charts.

S&P Trendline Chart Guide is about $145 per year. It provides over
4,000 charts. These charts show one year of weekly price/volume
data and do not provide nearly the detail that Daily Graphs do.
You get what you pay for. There are other charting services
available. These are merely representative examples.

15. Can I get charts with a PC program?
Yes. There are many programs available for various prices. Daily
quotes run about $35 or so a month from Dial Data, for example. Or
you can manually enter the data from the newspaper.

16. What would a PC program do that a charting service doesn't?
Programs provide a wide range of technical analysis computations in
addition to moving averages. RSI, MACD, Stochastics, etc., are
routinely included. See Murphy's book [Ref 1] for definitions.
Frequently you can change the length of the moving averages or
other parameters. As another example, AIQ StockExpert provides an
"expert rating" suggesting purchase or short depending on the
rating. Intermediate values of the rating are less conclusive.

17. What does a charting service do that a PC doesn't?
Charts generally contain a fair amount of fundamental information
such as sales, dividends, prior growth rates, institutional
ownership.

18. Can I draw my own charts?
Of course. For example, if you only want to follow a handful of
mutual funds of stocks, charting on a weekly basis is easy enough.
EMAs are also easy enough to compute, but will take a while to
overcome the lack of a suitable starting value.

19. What about wedges, exhaustion gaps, breakaway gaps, coils, saucer
bottoms, and all those other weird formations?
The answer is beyond the scope of this FAQ article. Such patterns
can be seen, particularly if you have a good imagination. Many
believe they are not reliable. There is some discussion in Murphy
[ref 1].

20. Are there any aspects of technical analysis that don't seem quite
so much like hokum or tea leaf reading?
The oscillator set known as "stochastics" (a bit of a misnomer) is
based on the observation that a stock which is advancing will tend
to close nearer to the high of the day than the low. The reverse
is true for declining stocks. It compares today's close to the
highest high and lowest low of the last five days. This indicator
attempts to provide a number which will indicate where you are in
the declining/advancing stage.

21. Can I develop my own technical indicators?
Yes. The problem is validating them via some sort of backtesting
procedure. This requires data and work. One suggestion is to
split the data into two time periods. Develop your indicator on
one half and then see if it still works on the other half. If you
aren't careful, you end up "curve fitting" your system to the data.

--------------------Check http://invest-faq.com/ for updates------------------

Subject: Technical Analysis - Bollinger Bands

Last-Revised: 12 Oct 2000
Contributed-By: John Bollinger (BBands at BollingerBands.com)

While there are many ways to use Bollinger Bands, following are a few
rules that serve as a good beginning point.
1. Bollinger Bands provide a relative definition of high and low.
2. That relative definition can be used to compare price action and
indicator action to arrive at rigorous buy and sell decisions.
3. Appropriate indicators can be derived from momentum, volume,
sentiment, open interest, inter-market data, etc.
4. Volatility and trend have already been deployed in the construction
of Bollinger Bands, so their use for confirmation of price action
is not recommended.
5. The indicators used should not be directly related to one another.
For example, you might use one momentum indicator and one volume
indicator successfully, but two momentum indicators aren't better
than one.
6. Bollinger Bands can also be used to clarify pure price patterns
such as "M" tops and "W" bottoms, momentum shifts, etc.
7. Price can, and does, walk up the upper Bollinger Band and down the
lower Bollinger Band.
8. Closes outside the Bollinger Bands are continuation signals, not
reversal signals. (This has been the basis for many successful
volatility breakout systems.)
9. The default parameters of 20 periods for the moving average and
standard deviation calculations, and two standard deviations for
the bandwidth are just that, defaults. The actual parameters
needed for any given market/task may be different.
10. The average deployed should not be the best one for crossovers.
Rather, it should be descriptive of the intermediate-term trend.
11. If the average is lengthened the number of standard deviations
needs to be increased simultaneously; from 2 at 20 periods, to 2.5
at 50 periods. Likewise, if the average is shortened the number of
standard deviations should be reduced; from 2 at 20 periods, to 1.5
at 10 periods.
12. Bollinger Bands are based upon a simple moving average. This is
because a simple moving average is used in the standard deviation
calculation and we wish to be logically consistent.
13. Make no statistical assumptions based on the use of the standard
deviation calculation in the construction of the bands. The sample
size in most deployments of Bollinger Bands is simply too small for
statistical significance.
14. Finally, tags of the bands are just that, tags not signals. A
tag of the upper Bollinger Band is NOT in-and-of-itself a sell
signal. A tag of the lower Bollinger Band is NOT in-and-of-itself
a buy signal. For a free tutorial on Bollinger Bands, please visit
http://www.BollingerBands.com/services/bb/intro.asp

--------------------Check http://invest-faq.com/ for updates------------------

Subject: Technical Analysis - Black-Scholes Model

Last-Revised: 10 Apr 1997
Contributed-By: Kevin Lee (kevsterdtn at aol.com)

Black and Scholes are the mathmeticians who developed a model (formula)
that determines theoretical value of an option based on volatility and
time to expiration. Although this valuation is a theoretical value, it
is essentially the industry standard.

--------------------Check http://invest-faq.com/ for updates------------------

Subject: Technical Analysis - Commodity Channel Index

Last-Revised: 1 Apr 1997
Contributed-By: (anonymous), contact Chris Lott ( contact me )

The Commodity Channel Index (CCI) is a timing tool that works best with
seasonal or cyclical contracts. It keeps trades neutral in a sideways
moving market, and helps get in the market when a breakout occurs. A
moving average of the CCI can also be displayed. A constant number is
entered in the parameter screen to adjust the sensitivity of the index.
This will change the visual amplitude of the index lines.
FORMULAS: AVE = SUM OF LAST N PRICES / D
MEAN DEVIATION = SUM OF LAST (PRICE - AVE) / D
CCI = C * (PRICE - AVE) / MEAN DEVIATION
CCIAVE = OLD.CCIAVE + (SF * (CCI - OLD.CCIAVE))
SF: Smoothing Factor = 2 / (N + 1) where N = periods in ave,
or Smoothing Factor = 0 < SF < 1

PARAMETERS: 1st: Number of bars in the AVE average (ie. 5A).
Use the H,L,M,A study modifiers.
2nd: Multiplier constant C (usually 50-150).
3rd: Optional number of bars in the CCI average (ie. 3).
Example: 8,150,3

SCALE: Grid lines at the +100, 0 and -100 levels.

COLOR: 1st: CCI 2nd: Exponential average of CCI

HOW TO USE: Buy when CCI crosses ABOVE the +100 scale line.
Sell when CCI crosses BELOW the -100 scale line.

--------------------Check http://invest-faq.com/ for updates------------------

Subject: Technical Analysis - Charting Services

Last-Revised: 27 Apr 1997
Contributed-By: Joseph Shandling (jshandl at ucs.net)

Thanks to the many free quote servers on the net, you don't need to
subscribe to a data service or charting service just to get basic
charts. The following sites offer a whole range of charts for a
particular stock, as well as a lot of other information.

* Yahoo! Quotes at http://quote.yahoo.com
Offers 3-month, 1-year, 2-year and 5-year charts. No registration
is required. Pages for a stock include links to research, SEC
filings, etc, etc.
* DailyStocks at http://www.dailystocks.com
Offers various screens and many charts. No charge but registration
is required.

--------------------Check http://invest-faq.com/ for updates------------------

Subject: Technical Analysis - Data Sources

Last-Revised: 18 May 2002
Contributed-By: Zeyu Vicki Pei, Chris Lott ( contact me )

This article lists some sources of historical data. Note that
currencies are traded over-the-counter, there are no central exchanges
or market makers. Thus, currency closing prices are really just noisy,
"best guesses" collected from a number of different exchanges and
transactions.

* Yahoo has a fair amount of data, both for individual issues and for
indexes.
http://chart.yahoo.com/d
For information about what they provide, surf here:
http://biz.yahoo.com/f/c.html#historical

* Investors Alliance
219 Commercial Boulevard, Fort Lauderdale, FL 33308, 305-491-5100,
http://www.powerinvestor.com

* Micro Data
Offers closing prices on stocks, futures, indexes, mutual funds,
and money market funds in zipped ascii files, all for just $200 per
year.
http://www.micro-data.com

* Bull & Bear of Italy offers historical data and end-of-date updates
for markets in Great Britain, Germany, France, Italy, Switzerland,
Holland, Belgium, Spain, Finland, USA, Japan, Australia, and
Singapore. Annual subscription is Euro400. Please visit their
site at http://www.bullbear.it/site/english

* Ed Savage (contact egsavage at yahoo.com) maintains a collection of
data. Stated purpose: "To collect publicly available market data
in one place so people can access it easily." Donate "freely
redistributable" data or access same at this URL:
http://metalab.unc.edu/pub/archives/misc.invest It is NOT a
real-time, 15-min delay, or close-of-day quote server.

--------------------Check http://invest-faq.com/ for updates------------------

Subject: Technical Analysis - Elliott Wave Theory

Last-Revised: 12 Dec 1996
Contributed-By: (Original author unknown), Chris Lott ( contact me )

This article introduces Elliott Wave Theory.

background

R. N. Elliott "discovered" the wave theory in the early 1934. It is a
method for explaining stock market movements. Actually, Elliott wave
theory helps explain economics in general, but the stock market tends to
have three attributes that make it quite applicable:
1. It is a true free market (i.e., prices are not fixed by the
supplier, but rather set by the consumer).
2. It provides consistent and regular metrics that can be measured.
3. It is manipulated by a statistically significantly large group of
people.

Assumptions behind Elliott Wave theory

* The market is NOT efficient. Rather it is an inefficient market
place that is controlled by the whims of the masses. The masses
consistently overreact and will make things over and under priced
consistently. This was, and until recently, in direct opposition
to prevailing theories that the market place was an efficient
mechanism. The efficient marketplace was the theory that was
taught in B-schools and often continues to be taught until this
day.
* That if the above is true, then you should be able to do a
"sociological" survey of stock prices independent of other news
that effects stock prices. ie., you will be measuring the global
effects that the masses will have on the stock. (An interesting
aside. We have all observed that stock prices move independently
or in the opposite direction that news about the company, the
economy, or the stock would tend to let us believe. The general
explanation for this behavior is that the masses tend to listen for
the news they are ready to hear, and that the movement that
actually happens depends on other effects.)

General Principle of Elliott Waves

There are many things that have to be accounted for when doing e-wave
studies of stocks, and that one of the most difficult things to overcome
is the personal ability to separate your own emotions from affecting
your analysis. You as a person have the same types of fear/greed
internal mechanisms that affect the entire market place as a whole and
without being able to work to dismiss those emotions you will not be
able to sit in a position that allows you to understand and profit from
the sociological effects that you are measuring. That basic fear/greed
mechanism is so inbred to our existence that will keep the Elliott wave
a valid study regardless the number of people that know and understand
it.

This is an important point: Elliott Theory measures sociological
performance of the masses and these sociological functions are so
ingrained that even if individuals or many individuals are able to
understand and dismiss those actions the majority of the people will not
be able to.

Elliott waves describe the basic movement of stock prices. It states
that in general there will be 5 waves in a given direction followed by
usually what is termed and ABC correction or 5 waves in the opposite
direction.

Wave Description

The following wave description applies to a market moving upwards. In a
down market (perhaps the stock is truly overpriced and the market has
turned), you will generally see the same types of behavior in reverse
that you saw watching the stock on the way up.

Wave 1
The stock makes its initial move upwards. This is usually caused
by a relatively small number of people that all of the sudden (for
a variety of reasons real or imagined) feel that the previous price
of the stock was cheap and therefore worth buying, causing the
price to go up.
Wave 2
The stock is considered overvalued. At this point enough people
who were in the original wave consider the stock overvalued and
take profits. This causes the stock to go down. However in
general the stock will not make it to it's previous lows before the
stock is considered cheap again.
Wave 3
This is usually the longest and strongest wave. More people have
found out about the stock, more people want the stock and they buy
it for a higher and higher price. This wave usually exceeds the
tops created at the end of wave 1.
Wave 4
At this point people again take profits because the stock is again
considered expensive. This wave tends to be weak because their are
usually more people that are still bullish on the stock and after
some profit taking comes wave 5.
Wave 5
This is the point that most people get on the stock, and is most
driven by hysteria. People will come up with lots of reasons to
buy the stock, and won't listen to reasons not to. At this point
contrarians will probably notice that the stock has very little
negative news and start shorting the stock. And at this point is
where the stock becomes the most overpriced. At this point the
stock will move into one of two patterns, either an ABC correction
or starting over with wave 1.

An ABC correction is when the stock will go down/up/down in
preparing for another 5 way cycle up. During this time frame
volatility is usually much less then the previous 5 wave cycle, and
what is generally happening is the market is taking a pause while
fundamentals catch up. It is interesting to note here that you can
have many ABC corrections happening. For instance if the
fundamentals do not catch up you will have two ABC corrections and
then the stock will have a 5 wave down cycle. (Odd number of ABC
corrections lead to the stock going up, even numbers lead to the
stock going down.)

Length and quantity of the moves

People tend to think of something being too expensive or cheap for the
very same reasons that they think something is attractive or not
attractive. This subjective judgement is called aesthetics. A measure
of what is aesthetically pleasing has to do with fibonacci sequences.
They are all around us, they describe art, snail shells, galaxies,
flower petals, and yes, our own internal feelings of value.

The quantity of time and movement of a stock through a wave cycle tends
to measured reasonably well by fibonacci sequences. The measurement and
prediction of waves tends to be bound by these numbers and by the
fibonacci fractions (Roughly 5/8 and 1 5/8 and their inverses)

For more information, visit the Elliott Wave site:
http://www.elliottwave.com/

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Compilation Copyright (c) 2003 by Christopher Lott.