Accounting for Option Buyers

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Accounting for Option Buyers

 

 

AuthorAccounting for Futures Contracts

CA. Rahul Lodaya

 

 

 


Growth at a geometric progression is very addictive!!! And as I recall the days when I initially started to learn about option buying, the introduction to this concept was given as “place a bet on Rs 100 just by risking Rs 10”. How lucrative an earning opportunity does this sound to be!!!
And then as I dived deeper into these, I realized that Option Buying has its own intricacies & is an attractive & sweet bait to lose money if not traded well.
Nevertheless, I am here to discuss the aftereffects of Option Buying. Accounting for option buyers is something that this write-up shall cover.
EXPLANATORY NOTES- The coverage of an option buyers contracts in the market is all a play of choosing the right strike price & the right entry point. In a market that is unfavorable from an option buyer’s perspective as time is the biggest enemy what an option buyer faces in the market. However, the loss of a buyer is restricted to the premium prevailing on the ticker as & when he is entering the contract. Noteworthy point is that Option Buyer has to discharge the option premium, upfront in cash only. Collaterals are not allowed, as are allowed for option sellers. For this very reason, even the marked to market margins are not initiated for option buyers as the entire amount is paid up front.
The system explained below is applicable to both intraday as well as positional trades executed.
SYSTEMS SETUP – The system for accounting for option buyer would not involve the margins, like how it had been done for the futures contracts. However, it has its own set of principles to be followed.
Ledgers to be created in the books-
Account Name
Head of Account
Broker’s Account
Current Asset
Bank Account
Current Asset
Brokerage & Other Charges
Direct Expenses
Options Control Account
Current Asset
Option Premium Entry Account
Purchase Account
Option Premium Exit Account
Sales Account
Profit on Option Trade Account
Current Asset
Loss on Option Trade Account
Current Asset
ACCOUNTING FOR LONG OPTION CONTRACTS –
Assumptions for simplicity purposes –
  1. Trader has an overdraft facility from the banker.
  2. The option contracts are taken as a single unit, even though the exchanges trade options in lots.
  3. Brokerage is paid only on settlement
Trade No 1 – Long Call of Nifty 17,100 for March Expiry trading at Rs 200. Position squared off, same day at Rs 250.
Debit A/c
Credit A/c
Reason
Amount
Option Premium Entry Account
Options Control Account
Entering the contract
200
Options Control Account
Option Premium Exit Account
Exiting the contract
250
Brokerage & Other Charges
Broker’s Account
Brokerage charged
5
Profit on Option Trade Account
Options Control Account
Booking Naked profit
50
Broker’s Account
Profit on Option Trade Account
Booking a receivable from broker
50
Trade No 2 – Long Put of Nifty 17,500 for March Expiry trading at Rs 340. Position squared off the next day at Rs 300.
Debit A/c
Credit A/c
Reason
Amount
Option Premium Entry Account
Options Control Account
Entering the contract
340
Options Control Account
Option Premium Exit Account
Exiting the contract
300
Brokerage & Other Charges
Broker’s Account
Brokerage charged
5
Options Control Account
Loss on Option Trade Account
Booking Naked Loss
40
Loss on Option Trade Account
Broker’s Account
Booking a payable from broker
40
Trade No 3 – Long Call Nifty 18,500 for April Expiry trading at Rs 70. Position open as on 31st March, value of call at Rs 60 on that date.
Debit A/c
Credit A/c
Reason
Amount
Option Premium Entry Account
Options Control Account
Entering the contract
70
Options Control Account
Loss on Option Trade Account
Booking unrealized Loss
10
Intentionally left blank
Effects of all 3 trades –
Particulars
Trade 1
Trade 2
Trade 3
Total
Option Premium Entry Account
200
340
70
610
Option Premium Exit Account
250
300
550
Options Control Account
-200+250-50
-340+300+40
-70+10
-60
Brokerage & Other Charges
2
2
0
4
Broker’s Account
-2+50
-2-40
6
Profit on Option Trade Account
50-50
0
0
Loss on Option Trade Account
0
-40+40
-10
10
Rationale behind using control account & separate profit & loss accounts –
The control account serves as an indicator to disclose the position & exposure open in the market. On observing the table above, for every closed trade, the control account gets closed which clearly means that the trades still active in the market are captured.
Profit Account & Loss Account are simply running tools to determine the options turnover under the Income Tax Act. The simple mechanism to calculate options turnover under this system of accounting, on any given point of time is –
(Sum of Debits in Profit Account + Sum of Credits in Loss AccountClosing Balance of Profit AccountClosing Balance of Loss Account) + Sum of Option Premium Exit Account
Drawing up the financial statements
Balance Sheet (extract)
Capital
Rs
Asset
Rs
Options Control Account
(Open Positions in Option)
60
Profit & Loss (Loss Position)
64
Loss on Option Trade Account (Provision for Losses)
10
Broker’s Account
6
 Total
70
Total
70
Profit or Loss Statement (extract)
Expense
Rs
Income
Rs
Option Premium Entry Account
610
Option Premium Exit Account
550
Brokerage & Other Charges
4
Gross Loss
-64
Total
550
Total
550
EASE OF COMPLIANCE –
How to arrive at the futures turnover for Income Tax purposes?
The guidance note on tax audit quotes that the turnover shall be the sum of absolute profits & absolute losses along with the “sell value” of premium in initiating/squaring off an option transaction. The working is as under –
Particulars
 
Rs
Sum of Debits in Profit Account
+
50
Sum of Credits in Loss Account
+
50
Closing Balance of Profit Account
0
Closing Balance of Loss Account
10
Sum of Option Premium Exit Account
+
550
Options Turnover
 
640
This system accounts for the unrealized gains/losses but facilitates the ease of turnover calculation from taxation perspective. Broker’s report is majorly compliant from a taxation point of view but could create intricacies in drawing up true & fair books of accounts.
Why I chose this system of Accounting?
  1. Easily reconstruct trades
  2. Keep track of compliances from taxation perspective
  3. Can be easily accounted with broker’s note & need not wait for the broker’s report
  4. Keep track of the open positions at a given point of time.
Stock options carry a physical delivery clause as well. The link to the SEBI Circular is given here. The accounting for physical delivery has not been discussed in this article. This article is purely for an option buyer who is trading them for differentials & not for delivery.
Thank you for patiently going through this article.
I am always open for questions & valuable suggestions.
Article on Accounting for Option sellers, soon to follow!!!
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