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Many considerations go into creating and running a successful trading entity. We’ll look at the most popular which get the most attention, right through to the most important, which usually get the least attention. Here is the list: 1. Entry signals 2. Risk management 3. Exit signals 4. Reliability 5. Reward to Risk 6. Opportunity 7. Capital management 8. Objectives 9. Familiarity with Markets 10. Resources 11. Mindset 12. Style 13. Management Most, and by most I mean probably close to 80-90% look at number 1 and that is it! That is a startling reality, but a reality nonetheless. But there is a reason this happens. Most new traders are unaware that such a large number of traders ultimately fail in this business, and more importantly, this fact is well known by the very people who market trading in this way. But enough of that, let’s look at some serious considerations you should make and the order in which you need to do it. Objectives – Set a target, a goal, a reason. Without this, you can’t create or find the right system for you. You won’t know whether the system will work for you, or even if it is on track or not once you begin trading it. Familiarity with the markets – Quite simply, markets move in similar patterns which is all good, but there are different costs, margins, hours of trade, laws etc associated with each market that need to be considered. Resources – These are your physical and mental assets. Everything from your time, capital, computer, to your mental strengths forms your list of resources. Day traders need different resources to a long term trader, not only in hard assets but mentally too. Mindset – This is part of your self-image. Your self-image influences your decision making process on a continual basis. It stands to reason a trader would only become successful if they were making the right decisions. You need to see yourself as a success first. Style – This is something you’ll need to work out way before you look at any system. Are you mechanical or discretionary, in other words, do you want a system to tell you what to do, or do you want to be analytical? Do you want to trade for growth or income (part of your objectives)? These sorts of styles all require different tools, and so it seems silly to purchase a system before you even know your preferred style. Once you have these aspects thoroughly researched and sorted out, I can guarantee you that finding or creating the right system of entry and exit tools will become far easier and much more enjoyable too. You’ll naturally be attracted to the type of market tools that suit you. But even then, once you find the entry and exit tools that suit you, there is more work to do. You need to back test and paper trade your entry and exit rules to determine the rest of the considerations mentioned above. Reliability – How reliable is the system for producing winning trades compared to losing trades, and does this suit you? The latter part of this question is the most important part. The reliability of the system does not tell you its overall profitability. It tells you your ratio of winning trades to losing trades, and this is a psychological question. Do you need to be right more times than wrong? This is the simple question you need to answer. Reward to Risk – What is the average profit per trade? This is your total net profits divided by your total number of trades (if your system has a net loss then it’s no good - obviously). When you know the average profit per trade of your system over a decent sample, you can then determine the number of trades you need to make to reach your objectives. Opportunity – Now that you know the number of trades you need to make over a time to reach your goals, you must determine whether or not your chosen markets will offer the opportunities you need. Will you need to trade in multiple markets, trade both long and short and so on? Capital Management – If you do find that your chosen markets offer enough opportunities for you to reach your goals, you need to consider if your capital can handle it. Many systems will require multiple positions open at one time in order to reach goals in a specified time. This means your capital may be stretched, or may not even cope. The size of your positions in the market is a part of your capital management and is also determined by whether or not you have leverage and the margin required. Risk Management – Risk is what you are willing to lose per trade. Your exit strategy aids in determining this factor, but it also needs to gel with you, because your risk per trade is a factor in you drawdown. The higher the risk, the higher the drawdowns and you need to know the maximum drawdown you’re willing to tolerate. Management – The final consideration we’ll cover here is management. You are controlling an entity and so management of all key areas is important. If you log each trade, you can assess for human errors, bad habits, you can also assess costs associated with trading and whether or not they can be reduced. In fact management is the part of your trading that is always looking for ways to improve the running of the business. If you look at the list above it can seem like a lot. If one was to think of what goes into creating the great business models like McDonald's, Starbucks and so on, then I don’t think it even compares. But why should it be so daunting? Enjoy the process and it will be a lot easier than you think. Dean Whittingham
I’m sure you’ve heard the saying “treat trading like a business.” Setting up a trading entity correctly is an important step if you are (or plan to be) a full-time trader. After reading this article you will have a grasp of: How a trading business functions What the components of a trading business are What kind of expenses can you write off It’s really quite simple, Hobby’s cost money, businesses make money. The purpose of a trading business is to capture profits just like an ordinary business. The difference is you are not selling a product or providing a service, therefore the real benefits of creating an entity around your trading business is for tax purposes. Forming Your Trading Entity The most common way to setup a trading entity is as a Limited Liability Company (LLC) in the state which you live. While tax laws vary from state to state, they don’t provide a significant advantage when setting up your trading entity. The name does not need to be extravagant, as the purpose of your LLC is to separate your trading capital from your personal investments, thus limiting your liability as the name states. No matter what state you file your entity in, you will need to draft your Articles of Organization, a document which includes your: Entity Name Purpose Known Place of Business Address Members and Percent of Ownership Member Signatures In most cases you will be the sole managing member of your trading entity. I recommend reviewing the information at IRS.gov on setting up an LLC. It is also effective to file your LLC taxed as an S-Corp. This is strictly for tax purposes as it makes the itemization process easier. Once you create your entity you can then file for an Employee Identification Number (EIN). This number will be used on all tax forms and trading accounts as this is how the IRS will identify your trading entity separate from your personal social security number. Your licensed tax professional will be able to walk you through this process and answer any questions you have along the way. I would check to see if they have experience with trading tax accounting as there is a lot of grey area in the current laws. Do you qualify for trader tax status? This is the first question you need to ask. I will reference Robert Green’s book, Tax Guide for Traders as this has become the industry standard for trader tax accounting. What is Trader Tax Status? There is no objective test to establish trader tax status qualification. The IRS developed the following criteria to determine if you’re eligible for trader tax status. 1. The taxpayer’s trading must be substantial, regular, frequent and continuous. Sporadic trading won’t be a trade or business. 2. The taxpayer seeks to catch the swings in the daily market movements and profit from these short-term changes rather than profiting from long-term holding of investments. As you can see the criteria is quite ambiguous, however if you are day trading the futures markets for example and are a full-time trader and have no other major sources of income to pay your living you qualify without question. If you are a part-time trader because you have another business activity, the IRS may scrutinize your qualification for trader tax status. What is Mark to Market Accounting? Mark-to-market (MTM) refers to the procedure you follow at year-end when you mark all your open positions to market prices. MTM only applies to trading gains and losses it does not apply to a trader’s business expenses. You must elect MTM accounting; it does not default when you file trader tax status. Commodities and futures use a different tax method than securities, the 60/40 rule. This means 60% is taxed at the long-term capital gains rate, and 40% at the short-term. MTM accounting is not a preferred method for profitable commodities and futures business traders because this blended 60/40 rate is significantly less than having your entire profits taxed at the short-term rate. What if You Have a Losing Year? Business taxpayers are allowed the benefit of net operating loss tax laws. These laws provide the opportunity to carry back and/or forward business losses. Make a fortune in one ear and pay your taxes then lose a fortune in the following years and carry back your net operating losses to get big refunds. What Expenses Can a Trading Business Write Off? Other benefits of setting up a trading entity are the ability to create retirement plans, deduct medical and health insurance premiums, and write off additional expenses such as computer equipment, travel to trade shows, and education materials. Since your trading gains and losses are considered ordinary gains and losses when electing MTM accounting you may deduct in full against any type of tax return income. The ability to deduct home office and education expenses and depreciation on computers and office equipment is a benefit not allotted to the typical investor. The business trader may use schedule C for these business expenses. Whether you decide to setup a trading entity and file for trader tax status or continue as a non-business trader, you must develop a detailed plan for the future if you want to succeed. Consult Your Tax Professional Make sure to consult with a licensed tax professional that is well versed in trader tax law. I am not a licensed tax professional nor am I affiliated with Robert Green’s Accounting Firm, Green Trader Tax. I just find their resources extremely helpful. Resources from this article: Tax Guide for Traders by Robert Green IRS.gov For more detailed information on Trading Futures visit the EminiMind blog.