Update: 2019 Budget, no more STT trap. STT on exercised options to be on intrinsic value from Sep 1st 2019. Check this.
Update: With effect from 31st August 2017, the exchanges have put in place a mechanism to address this anomaly. More details on this change here.
- Why do options trade at lesser than the theoretical value on the last day of expiry?
- Why is it important to square off ITM (in the money) options rather than let them expire on the expiry day?
Not knowing the answer to the above questions can cause a potential loss and hence the reason for writing this blog. I am assuming that all of you reading understand the basics of option trading.
Many of us would have had the following 2 questions or faced similar scenarios at some point of our trading career
- Nifty is trading at 5950 and today is the day of expiry. At around 2:00 PM, Nifty 5900 calls and 6000 puts are trading at around Rs 45. Ideally it should be at least 50, so why?
- I had bought Nifty 5800 calls and Nifty closed at 5803 on expiry day. I could have sold it on the exchange but thought otherwise and let it expire assuming I will get back at least Rs 225 (Rs 3 x 75)/lot. To my shock, the contract note sent to me by the broker in the evening showed a debit of Rs 200/lot and when I called the broker some lady on the support team told it was a penalty from the exchange or more STT or some similar reason, so why?
The seeming anomaly in the price or the extra debit in the above scenarios is because of how STT (Security Transaction Tax) is considered for options that are exercised. Options are considered exercised if you hold buy positions in options till the end of expiry (till after 3.30pm on last thursday of the month) and with them having some intrinsic value or being ITM (in the money).
STT on normal option trades done on the exchange is charged at 0.05% of the selling side of the premium value.
So, if you buy 1 lot of Nifty 5900 options at Rs 100 and sell it at Rs 100, you have to pay 0.05% of the premium value on the selling side. So while buying 50 x Rs 100 you don’t have to pay STT, but while selling you have to pay STT of Rs 3.75 [0.05% of Rs 7500 (75 x 100)]. Usually the STT component while trading options is almost insignificant, in this example it is only Rs 3.75.
STT on BUY option positions that get exercised is 0.125% of the entire CONTRACT VALUE.
So, if you had bought 1 lot of Nifty 5900 options at Rs 100 and didn’t sell it but let it expire on the last day of the contract, it is considered exercised. Again while buying there is no STT, but since it is exercised, on the selling side you would pay an STT of Rs 562.5* much higher than Rs 3.75 which you would have paid if sold on the exchange instead of exercising.
*Rs 375 = 0.125% of ( (5900+100) x 50). Rs 375 would mean more than 7 points of movement on Nifty options, that is how high the impact of STT could be. (assuming nifty lot size of 50)
Do remember that if you are short/written options (sold first), you have already paid STT and it doesn’t matter if you buy the options on the exchange or hold them till expiry to square off, there is no STT on the buying side.
Currency trading in India presently has no STT levied by the government and hence you don’t have to be worried about paying higher STT while trading currency options on the expiry day.
With this knowledge the above 2 scenarios will suddenly start making sense.
- It is the last day of expiry with Nifty at 5950 and if I buy 5900 calls or 6000 puts and I hold it till the end of the day I will have to pay STT of almost Rs 560 (0.125% of (5900+50)*75) which is almost 8 points of movement on Nifty options. So a 5900 call/ 6000 put which should be trading above 50 if nifty is at 5950 will have to factor in this 8 points as STT, hence the value of ITM options will seem lesser on the last day of expiry. So a Nifty 5900 call which should be at least 50 if Nifty is around 5950 will be at 45, because everyone trading is factoring in the fact that STT will be much higher if the option is held till the end of that day. Similarly with the puts as well.
- You had 5800 calls and Nifty futures closed on expiry at 5803. Yes, your contract note will show a credit from your option sale of Rs 225 (3×75) but since you let it expire in the money it is treated as an exercised option and hence your contract note will also have an STT debit of Rs 544 (0.125% of (5803*75)). So net, instead of receiving Rs 225, you will now end up having to pay Rs 319.
In gist, on expiry day,
- If you have bought options and they are expiring in the money, you would rather sell it on the exchange than let it expire/exercise and having to pay much higher STT.
- If the options are expiring worthless (with 0 value), you don’t have to sell it to save STT because STT on options which has no value is zero.
- If you see options which seem to be cheap (trading lesser than theoretical value), do consider the fact that it is so because of higher STT and will not magically correct before the end of the day.
Many traders every expiry fall into the STT trap by either not selling their ITM options and letting it expire (especially which are very close to strike price) or else taking trades/strategies assuming that discounted price of option will correct before the end of the expiry day.