The modified formula for STT on options will kick in from September 01. The STT is normally levied on both sides of a delivery trade in the market and only on the sell-side of intraday and derivatives trades. Let us look at why this was an anomaly in the case of options.
The options STT anomaly
STT on options have been charged at a concessional rate because it is charged on the premium value rather than on the notional value of the contract. This was one of the key factors that had made options very attractive to traders. However, one exception was when you let In-The-Money (ITM) options on F&O expiry day. When you left an ITM option to expire on the F&O expiry day then it would be treated as a delivery trade. That means the delivery STT rate of 0.125% used to be charged on the notional value of the option. For example, if you held an option on an Rs.700 strike price having lot size of 1000 shares, then the contract value would be Rs.7 lakhs. If the stock expired at Rs.705, on F&O expiry, it would be treated as ITM if you left it to expiry. So, you would end up paying STT of Rs.875, which would wipe away nearly 20% of your profits. Under the new STT pricing, you have to pay 0.125% on the moneyness of the option i.e. Rs.6.25. Effective the STT cost of ITM options has fallen by over 90%. But, why is this shift so important and how is it likely to impact option market volumes?
Enables aggressive trading
One of the reasons the ITM options are not traded very aggressively around the expiry is that they tend to become illiquid with sharp spreads. This makes trading in these options risky and hence most options traders tend to keep away from these contracts. ITM options give you the opportunity to trade in lieu of futures with an approximately similar return profile but lower risk. Due to lack of volumes in the last few days prior to expiry, these ITM contracts become very illiquid and hardly attract any buying interest. With the cost of STT coming down so sharply, it is likely to encourage traders to take risk and trade these options close to expiry as the overall cost is quite low and may not really impact your cash flows.
More structured hedging
Due to the current high STT cost on ITM options, hedgers faced a unique problem in that they had to close hedges rather than leaving them to expiry. Leaving hedged options to expiry is always a better method but with liquidity drying up and options quoting at a discount to intrinsic value, there is normally a rush to cover such options. This creates an unnecessary rush to close hedges and leave positions open. ITM options around expiry were also becoming a buyer’s market and the new STT rates will give a level playing field for traders and hedgers in options! ©