How 'do not exercise' feature will help options traders

The “do not exercise” facility given by stock exchanges for certain equity options is expected to iron out liquidity woes and result in savings for traders. Earlier, all in-the-money options contracts used to get “exercised” on the expiry day, thereby attracting securities transaction tax (STT) of 0.125 per cent, instead of the normal rate of 0.05 per cent. Moreover, the higher STT used to get imposed on notional value of contracts and not the premium amount. The theoretical reason for higher tax incidence was that expiring of in-the-money options was akin to buying or selling underlying security and hence, attracted STT similar to the cash market. In the past, exchanges made several representations to the government and the Securities and Exchange Board of India, saying the tax anomaly was creating imbalances in the market. Ahead of derivatives expiry, many options contracts used to turn illiquid as investors looked to close out their positions but didn’t find enough counter-parties. The differential tax treatment discouraged investors from actively participating, leading to pricing inefficiencies. 
 
Last week, the National Stock Exchange and the BSE allowed trading members the “do not exercise” facility on in-the-money call and put options with strikes near the final settlement price. This move will help traders freely operate in the derivatives space and improve liquidity and pricing.
 
To illustrate: On Thursday, the cost of a Nifty call option with strike of 9,500 was Rs 384. The seller of this option is charged STT of 0.05 per cent on Rs 384, the premium amount. The STT works out to around Rs 2. Assume on August 31, the derivative expiry day, the Nifty closes at 10,000. The 9,500 call option if not exercised will result in profit of Rs 500 (10,000-9,500). The STT will now be 0.125 per cent instead of 0.05 per cent and it will be charged on 9,500 and not the premium amount. This will result in STT of Rs 120. If the trader opts for the “do not exercise” option, STT will be charged at a lower rate.
 
Currently, however, the “do not exercise” option is only given on in-the-money call options with three strikes immediately below the final settlement price and three in-the-money put options with three strikes above the final settlement price. Nifty contracts have strike intervals of 50. So, if the final settlement price for Nifty is 10,000, the facility will be available only on call options of 9,850; 9,900 and 9,950 and put options strikes of 10,050 10,100 and 10,150. Market players say this facility should be extended to all in-the-money options to ensure full efficiency in options trading.