Why the Proposed Change to Option Expiry Rules Are Important?

The regulator has been consulting the exchanges about a proposed tweak to our existing equity and index options expiry rules. When a trader buys an option, he will be required to choose whether the option is for excise on expiry or not. This case specifically pertains to in-the-money options and the entire anomaly arises due to the different system of imposing securities transaction tax (STT) when an in-the-money option is left for expiry on the expiry day. To understand this proposed modification in rules, let us first understand the concept of in-the-money options in greater detail and why this discrepancy in the calculation of STT becomes so important.

So, what exactly is an In-The-Money (ITM) option?

An ITM option is an option that is having a positive intrinsic value. This could be applicable to call options and put options. As we all know, a call option is a right to buy a stock or an index while a put option is a right to sell. Let us first understand the concept of an ITM option from the point of view of a call option.

Let us assume that you have purchased a Nifty 10,000 Call Option expiring on 28^th September 2017 at a price of Rs.90. Since this is a call option, this is a right to buy the index at a strike price of Rs.10,000. If the value of the Nifty moves to 10,070 then it will be an ITM option as it has a positive intrinsic value of Rs.70 (10,070-10,000). Remember, you have bought the call option at Rs.91, so you are still losing Rs.21 but that is because you have also paid for time value. The call option will be classified as ITM if the Nifty is above the strike price and therefore has a positive intrinsic value. If the Nifty is at 10,000 then your call will be at the money (ATM) and if the Nifty is below 10,000, then the call option will be out of the money (OTM).

The concept of ITM in put option is the exact reverse that of a call option. Since put is an option to sell, it will be ITM if the market price is below the strike price.

Why STT on ITM options has become a major issue…

As we are aware, the exchange imposes 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? Here is why!

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 worked.

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/-. Yes that is correct!

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.

What is the tweaking all about?

The tweaking of the methodology of option expiry is proposed will enable traders to select whether they want to exercise the option or not. If they select “NO”, then the option will not be exercised on the expiry date. Of course, in that case it will be treated as a speculative income and taxed accordingly and then it cannot be classified as business income. But that is for another separate blog to really worry about!