InvestorQ : What is the relevance of STT to ITM options?
Bhavika Nehru made post

What is the relevance of STT to ITM options?

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Bhavik Nehru answered.
2 years ago

The stock exchange imposes securities transaction tax (STT) on all transactions in the stock market. In case of cash market transactions, the STT is imposed on the buy side and the sell side. But in case of derivative transactions the STT is only imposed on the sell side of the transaction. So if you sell futures, you pay STT of 0.01% while if you sell options you pay STT at 0.05%. Remember, the option STT used to be 0.017% till last year but in the recent Union Budget, Mr. Jaitley had increased the STT on selling options three-fold to 0.05%. Why is the STT on options 5-times the STT on futures?

The reason is that in case of futures, the STT is imposed on the notional value while in case of options it is imposed on the premium value. In case of futures, if you buy Nifty futures at 9900 then the STT at 0.01% will be calculated on the notional value of Rs.742,500 which will be Rs.74.25/lot. In case of options if you sell 10,000 Sept call option at Rs.90, then you pay STT on the option value of Rs.6750 which is Rs.3.35. The question is that when option STT is imposed on the seller of the option, why does the buyer have to worry about it? Let us now look at the curious case of STT at 0.125% on expiring ITM options…

There is a rule pertaining to options that if you leave an ITM option to expiry then the option will be deemed to have been exercised. When the option is excised, the STT of 0.125% will be imposed on the buyer of the option. Moreover, the STT in this case will be calculated on the notional value of the option and not on the option value. If you think this is nothing much, you will be surprised to know that the effect can actually be devastating. Consider this example…

Raghav had 1 lot of a 9900 Nifty call option which he had purchased at a price of Rs.11 in the beginning of the month when the Nifty was much lower. On the expiry date, the Nifty spot is quoting at Rs.9930 while the 9900 call option is trading at Rs.25. Raghav feels that if he sells the option in the market he only gets Rs.25 whereas if he lets it expire, he will get Rs.30. On the expiry day, the Nifty expires at 9930. Raghav was looking to make a healthy profit on 1 lot of Nifty but was in for a nasty surprise. That is because the exchange imposed 0.125% STT on the deemed excise of his ITM option. Here is how it works.

STT Cost = Notional Value * 0.125%. Notional Value = (9900+11)*75 = Rs.743,325

STT was calculated at 0.125% of the notional value = Rs.929/-. That is huge and that is precisely the problem. So Raghav made a profit of Rs.1,425 but paid Rs.929 as STT, leaving him with a net profit of just Rs.496/-. On the other hand, if he had sold the option in the market at Rs.25, he would have been better off. His total STT would have been (25*75*0.05%) = Rs.1 and his net profit would have been Rs.1049/lot. Effectively, he would have saved Rs.928 as STT by selling the option instead of leaving it to expiry. The moral of the story is that when options are in-the-money (ITM) it makes more sense to sell the option than leave it to expiry.