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Your trading strategies should be tax efficient. So, this week, we discuss tax-aware trading. This refers to comparing trade set-up in the spot (cash) and the derivatives (F&O segment) market to determine which of the two venues is tax efficient for a given view on the underlying.
Gains, losses
The following discussion refers only to short-term trading in the stock market. If you initiate position trades in the spot market, you must pay 20 per cent short-term capital gains tax if you hold your positions for less than 12 months. If you trade intra-day, your gains are considered speculative and taxed at your marginal tax rate. Importantly, speculative losses can be set off only against speculative gains or carried forward to be set off against speculative gains for a maximum period of four years.
Gains from derivatives trading are considered business income, whether intra-day or position trades. And all gains are taxed at your marginal tax rate. The difference from intra-day spot trades lies in how you are allowed to set off and carry forward your derivative trading losses. You can set off losses on derivative trades against any income other than salary for the year. Also, you can carry forward losses to set off against business income for a maximum of eight years.
The above discussion leads to a simple conclusion. If you want to set up a long position as part of your trading portfolio, first check if derivatives are available on the underlying. If so, consider your view on the underlying. If you are confident of an uptrend, you should consider going long on futures instead of on the underlying. For one, even if you were to close the futures position intra-day, your tax treatment will be same as in the case of a position trade. For another, futures contract allows you to leverage your capital; you only pay an initial margin and mark-to-market margin as opposed to paying the entire amount upfront for an equivalent position in the underlying.
The argument is the same for options. Traders typically prefer options when they are relatively less confident about the underlying trend. This is because of the asymmetric pay-off associated with option contracts — the upside potential is greater than the downside risk (limited to the option premium). Importantly, trading options is more tax efficient than trading the underlying, whether you are closing positions intra-day to take gains or cut losses.
Optional reading
Tax-aware trading actively considers the tax implications before setting up a position. This is not the same as determining the reward-to-risk ratio of an intended trade that considers trading costs such as brokerage commissions and securities transaction tax. Rather, tax-aware trading is at the macro-level. The rule is simple: Consider futures and options on stocks and indices, when possible, instead of short-term trades in the spot market. Note that tax-aware trading is different from tax-loss harvesting. The latter refers to selling loss-making positions with the intention to reduce taxes on gains from profitable positions.
The author offers training programmes for individuals to manage their personal investments
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