InvestorQ : Is the STT impact on options really that material to worry about?
Niraja Mehta made post

Is the STT impact on options really that material to worry about?

Mary Joseph answered.
4 years ago

Yes it is very material and can make a difference to profits. That is why you need to worry about that. 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 expiry

You reverse your ITM option before expiry

Option Details: Bought 9950 Nifty Call @ Rs.75

Option Details: Bought 9950 Nifty Call @ Rs.75

Nifty Spot Value just before expiry – 10,075

Market price of 9950 Call Option – Rs.115

Notional Value of contract – Rs.751,875

Option Value of contract – Rs.5625

STT at 0.125% on contract value – Rs.940

STT at 0.05% on option value – Rs.3

Net Profit = (50*75)- 940 = Rs.2810

Net Profit = (40*75) – 3 = Rs.2997

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!