The cost of trading options and futures will rise from October 1, as the recent Budget has increased the Securities Transaction Tax (STT) on these instruments. While the increase may seem marginal, you must be aware of the total transaction cost before initiating trades, especially in options. This week, we discuss how to initiate cost-aware trades. 

Determining potential gains

The series of steps you must take to initiate a trade are as follows: First, you must determine if the underlying is likely to move up or down. If you have a positive view, you may decide to initiate long futures, long call, or short put position. If you have a negative view, you may decide to initiate short futures, long put, or short call position.

Second, you must determine your price target. This could be based on, say, a price measure rule or applying a Fibonacci ratio to the distance between the support and the resistance levels.

Third, you must determine the gains the position can offer if the price target is achieved at expiry. While this assumption may not matter much for futures, it does have a significant implication for options. Why? Options are wasting assets. That is, the time value component of the option price will decline with each passing day. At expiry, time value of the option will be zero. Importantly, time value of an option is a residual factor that is calculated by backing out the intrinsic value of an option from the option price for an in-the-money (ITM) strike. An out-of-the-money option (OTM) has only time value.

At expiry, with the time value being zero, an ITM option will carry only intrinsic value and an OTM option will have zero value. Intrinsic value of an option can be easily determined if you have the strike price and the spot price. But time value of an option price cannot be determined unless you have an option price. Therefore, it is easy to determine the price of an option at expiry, but not any time before expiry. If your intended position offers significant gains when the price target is achieved at expiry with zero time value, then the position ought to generate larger gains any time before expiry, as the option will also carry some time value. 

Finally, you can determine the cost of trading the option using a brokerage calculator available on the Internet. You must enter the position only if the trade is profitable after incorporating the costs including STT. 

Traders, beware
The average trading cost adds 28 per cent to loss-making trades and accounts for 15-50 per cent of gains on profitable trades
Optional reading

The risk disclosure statement that you accept when you login to your trading account is a reminder of how trading costs can hurt your position. The average trading cost adds 28 per cent to loss-making trades and accounts for 15-50 per cent of gains on profitable trades! This cost will go up with the increase in STT. The upshot? You must be mindful of trading options for smaller gains. 

The author offers training programmes for individuals to manage their personal investments

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