I have previously explained wash trading, which is an illegal and prohibited practice for a long time now. However, there is a similar stock trading activity that is legal in some situations and practiced all the time, it is called a wash sale. A wash sale is the process by which someone sells his losing shares for tax deduction purpose, only to buy them back in the new year.

For example, let’s assume that someone bought a 1,000 shares of BAC at the beginning of the year when they were trading around $15. Assuming BAC closes the year 2011 at around $8, that individual will be left with a loss of $7,000. What that person does is that he sells these stocks at the end of the year, claiming an unrealized loss on his taxes, and then buys the 1,000 shares again in January, thinking that BAC will recover. As you probably would have guessed, a wash sale is the main reason behind the January effect. It is important to note that in the US, an investor cannot claim an unrealized loss from this transaction if he buys back the same securities in less than a month after he sells them. However, he’s able to add the loss, per share, to the price of each share he buys back. Let me explain, say the investor above buys back the stock at $9 in January of next year, if, at one point in 2012, the investor sells his BAC shares at $20 each, then he will only have to report gains (for tax purposes) based on the stock price of $16 ($9 price of the stock when he purchased it the second time plus $7 his loss from his first purchase). I know what most people will think right now, that a wash sale is essentially useless. Maybe, I wouldn’t care about doing it myself as I personally don’t see the point…

You can clearly see that a wash sale is completely different from a wash trade, where in the latter case, an investor buys and sells the same security in order to artificially inflate the volume and attract other investors.