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Tax Loss Selling

"Hi, we’re from the government, and we’re here to help you."

Most people run like hell when they hear that. Government bureaucrats may have good intentions, but dealing with them usually ranks somewhere between alligator wrestling and trying to herd cats.

Except when the good folks at the IRS set off an annual ritual called tax-loss selling. That’s when the government really is there to help you – if you know how to profit from simple IRS rules.

What is tax-loss selling? Put simply, you pay your taxes on April 15, but your capital gains or losses from stock trading are calculated through the previous December 31. This creates a powerful incentive for investors to sell their losers before the New Year rolls around, and to hang onto their winners.

Sell your losers and take your losses now – that is tax-loss selling in a nutshell.

Lots of otherwise decent companies see their stock price pushed down sharply in November-December, thanks to tax-loss selling. Not-so-decent companies often get absolutely crushed as longs abandon their last shred of hope, and decide to book a tax loss in what looked like a great investment just weeks or months before.

How can you profit? By shorting the companies you think will fall victim to the tax-loss selling axe. Shorting isn’t always easy, but the tax-loss season gives shorts an extra advantage. Everyone is gunning for the weakest members of the herd.

Think of it as a short-selling feeding frenzy.

Here are some basic guidelines for finding tax-loss selling candidates. First, look for stocks that traded well above their current price for much of the year. Check out the daily volume and see if the high-price period corresponds with high volume too. That means a lot of folks bought the stock at much higher prices than now. They may sell it for the tax loss before December 31.

There is no magic number that marks a tax-loss selling candidate. If you are running a scan, look for companies trading at least 30% off their 1999 highs, and preferably 50% or more.

Next, look for companies with large floats, i.e. a lot of shares available for the public to trade. This is a good rule for short-selling in general. Stocks with small floats (less than 5 million shares) can be hard to borrow and short to begin with. If they are already heavily shorted, the chances are greater you could get caught in a "squeeze" as the price runs up and shorts are forced to cover at desperation prices.

(Tax-loss "covering" also comes into play with shorts; if a heavily shorted stock has already dropped a lot, shorts may not buy back shares to cover their position at a profit until the next tax year, leaving the company with no buyers at all in late December)

Third, look for companies that either don’t have a marketable product, or they make a commodity product that many other companies can easily duplicate.

Finally, look for basic financial criteria that would normally tell you NOT to go long in a stock – very low cash on hand, low book value, low tangible book value (when the balance sheet has been inflated with "goodwill" from acquisitions) and super-high Price-Sales ratios.

A good tax-loss selling candidate will have a balance sheet that smells like something between stale milk and a sewage treatment plant.

Since tax-loss shorting isn’t part of your fundamental investment strategy, keep a close eye on your plays and don’t let any one short trade turn into a big loser. Put in a 10% "buy to cover" stop over your entry price and walk away if it trips. No big deal if one trade yields a small loss; better than one small trade turning into a 50-100% loss in a short squeeze.