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Chapter 1 Introduction to STT Trap

STT Trap

STT Trap: Present Scenario
Trading in Futures & Options (F&O) without having a complete knowledge of the settlement mechanism can be extremely risky.
Most newcomers, who trade options with a desire to make huge profits by buying cheap options on the day of expiry make a common mistake and get caught in the STT trap. Thus, these traders end up with huge losses, usually higher than the premium amount they paid at the onset.
What is STT?
STT stands for security transaction tax.
This tax is levied on every purchase or sale of securities listed on the Indian stock exchanges. This includes shares, derivatives, or equity-oriented mutual fund units.
P Chidambaram, then finance minister, had introduced this tax in the Union Budget for 2004-05.
STT was introduced to curb tax evasion on capital gains. Prior to this, many traders refrained from declaring their profits from the sale of securities and avoided paying capital gains tax.
STT in F&O Segment

Sr. No. Taxable securities transaction New rate from 
01.06.2016
Payable by
(a) Sale of an option in securities 0.05% Seller
(b) Sale of an option in securities, where option is exercised 0.125% Purchaser
(c) Sale of a futures in securities 0.01% Seller

(Source: NSE)

Understanding the STT trap

Lots purchased 200 lots, Nifty 10800CE
Cost of purchasing 200CE options 1.2(Premium)*75*200 = Rs18,000
CMP of Nifty at 3PM 10,780
Price of Nifty at 3:30 PM on expiry 10,803
Profit Expected 3(Intrinsic value)*75(Nifty lot size)*200 = Rs45,000

Consider this situation: A trader purchases 200 lots of Nifty 10800CE option on the last day of the expiry, when markets are trading at 10,780, expecting the market to give a close above 10,800.
Nifty, to the trader’s delight, does manage to give a close above 10,800 at 10,803. However, the trader does not exercise his option and has it automatically exercised by the exchange in order to save on brokerage charges. He is expecting to make a profit of Rs45,000, but, to his horror, when he receives his contract note it shows a loss of Rs1,57,556.
The reason behind this loss was the exceptionally high STT charged by the exchange on in-the-money (ITM) options that were not exercised by the trader before 3:30 pm on the expiry day.
Why is it extremely important to square off your ITM options position rather than letting it get automatically squared off?
On normal option trades that are squared off before 3:30 pm on the expiry day, STT is charged at 0.05% on the selling side of the premium value. The trader does not pay STT on option at the time of the purchase. A writer of an option pays STT at the time of writing the option, while an option buyer pays STT at the time of squaring off his position.
In our trader’s case, if he had squared off his position, the STT he would pay would have been:
STT= Selling premium*Lot Size*No of contracts *STT Rate
i.e., STT = 3*75*200*0.0005= Rs22.5, which is an insignificant amount.
The case stands true even when we trade in put options.
The problem arises when the trader lets his ITM option get automatically exercised. STT in such a scenario is computed differently.
STT= Contract Value*0.125%
Where Contract Value = (Strike Price + Premium)*Lot Size
STT = (10800+3)*75*200*0.00125 = Rs2,02,556
Thus, instead of receiving a fair profit of Rs45,000, as he was expecting, the trader faces a huge loss of Rs1,57,556 (2,02,556-45,000).
Options are automatically exercised if you continue to hold buy positions even after the market closes on expiry day if they have some intrinsic value. In such cases, an additional STT of 0.125% is charged instead of the normal levy of 0.05%.
In case the option is out-of-the-money or at-the-money, no STT is charged as the option expires worthless. Hence, if a trader does not square of such positions, he does not have to pay additional STT.
This problem is faced only by the options buyer, as the options writer (seller of the option) has paid the STT right at the onset.
Why the additional STT?
If the trader does not exercise the ITM option contract on the expiry day, it is assumed he will take delivery or provide delivery of the underlying security. The trader has the right to take delivery of the underlying security in case he has purchased a call option or is ready to provide delivery in case he has purchased a put option.
In the Indian markets, all equity derivative contracts are cash-settled, hence, there is no actual physical delivery of the underlying. But according to the theoretical contract, since the trader has asked for delivery, or agreed to provide delivery of the underlying security, STT is charged as per delivery-based equity transaction, which was originally set at 0.125% (later revised to 0.1% w.e.f 2013)
Hence, ITM options that are exercised are charged 0.125% STT.
Major changes brought about by the exchanges to fix this issue
Recently, stock exchanges came up with the facility of ‘Do not Exercise’ in equity options.
As per this facility, a file containing CTM (close to the money) contract details is made available for download on the expiry day. The file contains all the CTM long positions in both call and put options. The default exercise flag is set to ‘Y’ (Yes), and a file-upload facility is provided to the members. Members have the option to change the default exercise flag from ‘Y’ to ‘N’, indicating that they do not wish to exercise the position which was being automatically exercised previously. A response file is then generated for each file uploaded.
The CTM strikes range is arrived as under:
1. For Call Options: Three ITM options strikes immediately below the final settlement price shall be considered as ‘CTM’
2. For Put Options: Three ITM options strikes immediately above the final settlement price shall be considered as ‘CTM’
For e.g., If the market closes at 10,803 at the time of expiry, the following three strikes will be considered ITM:

Call Option Put Option
10,800 10,850
10,750 10,900
10,700 10,950

All the remaining ITM option contracts that are not in the ‘CTM’ option series are exercised automatically as per existing practice. Hence, if a trader purchases a 10600CE option and the market closes at 10803 on expiry, the trader will be liable to pay the higher STT of 0.125% if he lets his option get automatically exercised.
A member can upload the file specifying exercise instructions multiple times till the cut off time. If the member does not provide any preference within the cut-off time, or if the information provided by the member is incomplete or invalid, then as per existing procedure, the option will be automatically exercised. Positions where exercise flag is indicated as ‘N’ by the cut-off time shall not be exercised.

File format and timelines is as follows:

Sr. No. Particulars Annexure
Reference
Tentative
Timelines
(1) File providing the details of CTM
contracts
Annexure 1 4 pm
(2) File providing the details of CTM
Positions
Annexure 2 4:30 pm
(3) File to be uploaded by member
for ‘Do not Exercise’ instruction
Annexure 3 4:30 pm-5 pm
(4) Return file for ‘Do not Exercise’ instruction uploaded by member Annexure 4 4:30 pm-5 pm
(Source: NSE)
Trading members are required to provide ‘Do not Exercise’ instructions for their clients as well as for proprietary positions. Trading-cum-clearing members are required to provide exercise instructions for their Custodian Participant positions in addition to their clients and proprietary positions. Professional Clearing Members are required to confirm for their Custodian Participant positions only.
This functionality has been introduced for all weekly as well as monthly expiries with effect from August 31, 2017.