Effect of STT on Option Exercise

Equity and derivatives transactions in the stock exchange have been attracting securities transaction tax (STT) since 2004. There have been several changes to the imposition of STT since it was first introduced 13 years ago. For example, the rates of STT on equity and on F&O have been substantially brought down compared to what they were in 2004. Secondly, there has been a fine tuning of the definition of volumes in case of derivatives. So, while the STT on futures transactions is still imposed on the notional value of the transaction, the STT on options transactions is imposed on the premium value of the transaction. Let us understand how this difference works out
 

The case of STT on FuturesThe case of STT on OptionsAssume Nifty Futures price at 9900Assume Nifty 9950 Call Premium at Rs.50Lot size applicable – 75 SharesLot size applicable – 75 SharesNotional Value of 1 lot – Rs.742,500 (9900 X 75)Premium Value of 1 lot – Rs.3750 (75 X 50)Rate of STT charged - 0.01%Rate of STT charged – 0.05%Actual STT payable on 1 lot = Rs.74.25Actual STT payable on 1 lot = Rs.1.88STT payable by the – SellerSTT payable by the - Seller

As the above table clearly indicates, the STT payable on 1 lot of options is substantially lower than the STT payable on 1 lot of futures. This is despite the fact that the STT on options had been recently hiked 3-fold from 0.017% to 0.05%. The reason is that options are charged STT on their premium value while futures are charged STT on their notional value. This has been one of the key reasons for the rapid growth of option volumes in India.

Understanding ITM options and the concept of exercise
First, let us understand what is an "In-The-Money" (ITM) option? An ITM option is an option that has a positive intrinsic value. For example, if you bought a Nifty 9950 call option at a premium at Rs.50 and the Nifty spot is at Rs.9980, then the option will be an ITM option. Thus in case of call options, if the spot price is greater than the strike price it will be an ITM option. This is despite the fact that you are currently making a net loss on the position because although you are earning a profit of Rs.30, you have already paid Rs.50 as premium. ITM is just a pure comparison of the spot price with the strike price. In case of a put option, it will be an ITM option if the spot price is lower than the strike price. Here again, the option premium paid is not relevant.

Let us now dwell upon the concept of exercise of an option. There are American options and there are European options. A European option can be exercised only on the expiration date while an American option can also be exercised on any day prior to the expiry date. An exercise of an option is different from reversing your option in the market. Exercise has nothing to do with market liquidity and can be done with the exchange even if there is no liquidity in the market. Till 2011, index options were European in nature while stock options were American in nature. However, post 2011 NSE has shifted all its stock options also to the European format.
 
Then why to worry about exercise of options at all?
That is where the anomaly arises. While technically European options cannot be exercised, the anomaly arises on the expiry date. On that date all the ITM options that are not reversed by the holder of the option are automatically considered to be exercised at the closing price. The reason this is anomalous is that only in this case, the buyer of the option is required to pay the STT. Not only that, the STT is charged on the notional value of the contract (not at the option value) and is charged at the delivery rate of 0.125%. Therefore, on the expiry date if your option position is in-the-money then it makes a lot more economic sense to reverse and close out the option than to leave it to expiry. Let us understand the impact with the following live example
 

You leave an ITM option to expiryYou reverse your ITM option before expiryOption Details: Bought 9950 Nifty Call @ Rs.75Option Details: Bought 9950 Nifty Call @ Rs.75Nifty Spot Value just before expiry – 10,075Market price of 9950 Call Option – Rs.115Notional Value of contract – Rs.751,875Option Value of contract – Rs.5625STT at 0.125% on contract value – Rs.940STT at 0.05% on option value – Rs.3Net Profit = (50*75)- 940 = Rs.2810Net Profit = (40*75) – 3 = Rs.2997. Explore the Option value Calculator and get deeper insights.

 
As we can see in the above live example, when you leave the ITM option to expiry, you make a profit of Rs.50/share but that gets entirely eaten away by the higher STT which is imposed at 0.125% on the notional value. On the other hand, if you had reversed the option at a lower profit of Rs.40 per share, you would have ended up with a higher net profit due to the lower incidence of STT.

The issue of automatic exercise of ITM options is extremely important to remember. When you let ITM options to expire, they are deemed to be exercised. This results in a double whammy. Firstly, it results in STT being calculated at the delivery rate and secondly, the STT is calculated on the notional value rather than the premium value. So, don’t let the market spring a nasty surprise on you!