Wash Trading: Definition, Risks & How It Impacts Markets

Wash trading – also referred to as round trip trading – is an illegal practice where investors buy and sell the same financial instrumentsMarketable SecuritiesMarketable securities are unrestricted short-term financial instruments that are issued either for equity securities or for debt securities of a publicly listed company. The issuing company creates these instruments for the express purpose of raising funds to further finance business activities and expansion. at the same time in order to manipulate the market. The practice can unnaturally increase the trading volume in order to make the security appear as though it is more desirable than it actually is. It may also be done to provide brokers with commission fees to compensate for securities they can’t settle outright.

How Wash Trading Works

In order to execute a wash trade, an investor places both a sell order and a buy order for a security. The investor essentially sells the security to himself, which is essentially a form of insider tradingInsider TradingInsider trading refers to the practice of purchasing or selling a publicly-traded company’s securities while in possession of material information that is.

In the broadest terms, insider trading is the buying and selling of securities that the individual has more knowledge of than the general public. Because the investor is buying from and selling to himself, he has the most knowledge about the trade.

Example of a Wash Trade

Let’s say, for example, that an investor owns 50 shares of Company ABC and sells the shares on January 1 at a loss of $2,000. The investor then buys 50 shares in the same company on January 22 and subsequently realizes a gain of $4,000. A wash trade hasn’t technically occurred yet. The real wash trade is triggered when the investor seeks to claim a tax deduction for his original $2,000 loss.

If given the deduction, the investor offsets his taxes due on his $4,000 gain. It means that he pays less taxes on his earnings, despite the fact that he still ultimately owns the same amount of stock as he previously did. The U.S. Internal Revenue Service (IRS), however, taxes the investor on the full $4,000 gain from the later transaction because the purchase was made within the 30-day window. The true wash sale window is 61 days – 30 days before the sale, 30 days after the sale, and the day of the sale itself.

The Legal Aspect of Wash Trading

Some controversy still surrounds the buying and selling of securities between a few brokers. For example, is it legal if one broker sells a security to a different broker? Most in the financeFinanceCFI's Finance Articles are designed as self-study guides to learn important finance concepts online at your own pace. Browse hundreds of articles!, trading, and tax industries advise that the practice should be avoided because if nothing else, it could fall into the insider trading category.

The buying and selling don’t need to be done immediately. This is where many investors and brokers get themselves into trouble. If the buying and selling are done within a 30-day period, it could count as wash trading.

How to Avoid a Wash Trade

It is possible for investors and brokers to commit wash trades inadvertently. It is important for such individuals to catch themselves before they trigger a wash trade. It comes when tax losses are recognized. It happens when an investor disposes of an investment at a loss and then buys the same or almost identical investment within 30 days of the sale, either before or after.

Wash trading is highly illegal; however, it’s fairly easy for an investor to inadvertently fall into the wash sale trap when the time comes to recognize losses. For this reason, investors must pay close attention to when they buy and sell securities to avoid committing an illegal trade.

Additional Resources

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