Many individuals prefer day trading in shares. Our discussion of derivatives trading strategies in this column has been on positional trades — going long or short on futures and options, and carrying the position for more than one day. This week, we discuss the operational efficiency and tax advantage of day trading derivatives.

Operational efficiency and taxes

Your objective is to capture the change in underlying price during a day. Because of lower capital requirement, day trading derivatives is optimal compared to day trading in the spot market (cash market). You must pay only an upfront margin to trade futures or short options; buying options requires just the payment of a premium upfront. Of course, futures (long and short) and short option positions also require mark-to-market margin. Nevertheless, the total capital requirement is small compared to buying the same quantity of shares in the spot market. Also, shorting shares is expensive as you must typically borrow the shares for a fee to meet your delivery requirement. This suggests that derivatives are operationally efficient for day trading.

The choice between futures and options for day trading is not so clear-cut. Why? Futures can have a delta of one. That is, futures capture nearly one-to-one movement in the underlying. You can capture a similar delta by trading at-the-money (ATM) options. How? Given that an ATM option has a delta of approximately 0.50, you must buy two contracts of an ATM option to match the delta of the underlying or that of its futures. Note that time decay of the option is not a concern here because you are trading intra-day. So, the absolute gains from options and futures could be similar. Your gains in percentage could differ because options may require smaller capital compared to futures. Note that your stop loss for options must be approximately equal to delta times the stop loss on the futures price if you are trading index options; stop loss on all other contracts must be delta times the stop loss on the underlying price.

The tax treatment of gains and losses from day trading is different for shares compared to derivatives. Gains or losses from day trading of shares are considered speculative income. The point is that speculative gains can be offset only against speculative losses in any year. And speculative losses that you cannot set off in any year can be carried forward for only four years.

Points to note
Day trading in derivatives has lower capital requirement
Trading in derivatives is treated as non-speculative business income
Tax treatment of gains/losses from day trading is different for shares compared to derivatives

In contrast, trading in derivatives is treated as non-speculative business income even if you earn salary income; you must pay taxes based on your personal tax slab. Importantly, both day trading and position trading on derivatives have the same tax treatment. This is a great advantage. For one, you can set off gains from day trading derivatives with any other non-speculative business loss during a year. And you set off losses on your derivatives trading against any other head other than salary income during the year. Further, losses on derivatives that are not set off in a year can be carried forward for eight years. You can also claim (after consulting your tax advisor) deduction for expenses incidental to your derivatives trading.

Optional reading

Our discussion above is based on the premise that you are comfortable with day trading. Traders sometimes carry their intra-day positions to the next day to avoid taking losses. This may not change the tax treatment on the derivatives trade. But it could affect your trading profits over time if you are unable to contain your losses. Importantly, it could have an implication on your options strategy; for now, time decay is an additional factor that will drag down your profits. So, if you do not have a disciplined approach, operational efficiency and beneficial tax treatment cannot be good reasons for you to shift from positional trades to day trading derivatives.

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

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