Traders opt for a fiduciary call option in order to reduce their risk while also keeping cost of investment at the minimum, and targeting the same gains as costlier investments with higher risk.
What is a fiduciary call?
Fiduciary call is an option strategy that replaces what is known as protective put options (also known as married put options). that are more costly and require large upfront investment, with low cost and low capital input call options.
Let us understand how fiduciary call is preferable with an example:
Shares of Abcd Bank are trading at Rs 300 per share and the call and put options are each trading at Rs 50.
Strategy 1: Protective put
Rohini buys 100 shares of Abcd bank and also a put options contract of Abcd Bank for Rs 50.
So she spends:
Rs 300 x 100 shares = 30,000
Rs 50 x 100 shares = 5,000
Rohini is putting down a total of Rs 35,000
When the expiration date arrives, Rohini observes the stock price.
If it has increased beyond the strike price, she will not exercise her option.
If it is below the strike price she exercises the put option and her earnings are the difference between the current share price and the strike price, minus the premium she paid for the put.
Strategy 2: Fiduciary call
Mohini instead buys the call options contract for Rs 50.
She spends Rs 5,000.
She invests the other Rs 30,000 in some risk-free, guaranteed interest investment like fixed deposit or insurance. They may alternatively choose a very low-risk investment vehicle like government bonds.
Upon contract expiry, if the price of Abcd Bank’s shares has risen above the strike price, Mohini will redeem her risk-free investment and exercise her option. Her earnings are the difference between the strike price and the market value of the shares, minus the premium she paid for the call.
Now that you are clear on what a fiduciary call is, it is time to weigh it’s pros and cons, and factor in key considerations to decide if this is a good strategy for you.
Checklist and key considerations when using fiduciary call
The trader choosing to go with a fiduciary call needs to be very diligent and constantly mindful when choosing the risk-free investment. It should be liquid or it should mature on or before contract expiration. For example, if you are going for a fixed deposit of one year, you should ensure that the expiration date mentioned on the call options contract is 12 months from now or later, or you should ensure. You can opt for an early exercise on tour options contract; however, most interest-bearing and risk-free investment options either do not allow for liquidity or else levy a penalty for early withdrawal.
- Retaining sufficient capital
The amount of your risk-free and interest-bearing investment should cover the cost of paying for the options so as to exercise your right to buy, and actually take home the earnings from buying shares at a lower price than the market value.
You can alternatively have some other capital available for this purpose in case you have not managed to align the expiration date and redemption date. This might however call for more capital than the average investor has available with him (although to be fair, it is the equivalent of what he or she might have invested anyway if they went for a protective put).
- Know-how and expertise
You do need some amount of stock market experience and an understanding of futures and options to get things right. Beginner traders might want to trade this strategy using small amounts to begin with.
Additionally, let’s say the stock price does rally and you do exercise your call option. Now you’re holding stock and if you are to make earnings you’ll also need to know the right time to sell. Although you have made a favourable trade, it isn’t exactly money in the bank until you sell the shares at a profit after deducting fees and charges, accounting for inflation and so on.
Thirdly, even buying that call option for a certain strike price calls for some amount of speculation and making stock market predictions. For this, one needs a good handle on understanding the market and market forces.
Benefits of using fiduciary call
- Cost effective
Since the trader does not hold any shares through the period up until the expiration date, he or she does not end up paying the additional brokerage fees and charges related to holding a large volume of shares.
- Low upfront investment
As you would have definitely observed, Mohini gets to make a much lower up-front investment with her fiduciary call. Of course she does need to also invest in another risk-free or low-risk interest-bearing investment but she can always invest or save up gradually.
- Potential to earn incrementally
Depending on what is chosen for the low-risk or risk free investment – and the earnings on that investment – the investor has the chance to derive incremental earnings.
Going back to our earlier example;
Let’s say Mohini invested her remaining Rs 30,000 in a government bond that gave her interest of 20%.
And the stock price went up to Rs 350 per share, following which she exercised her call options contract.
She earns Rs 50 (difference between strike price and market value) x 100 shares = Rs 5000
She earns another Rs 6000 as interest from her government bond.
However, Rohini just earns the Rs 5,000
- Easy to navigate
You do not need any special software or technology to work a fiduciary call. No complex calculations need to be made. It is also one of the simpler options trading strategies that one can dabble with.
Even if you do go with a fiduciary call option as a strategy to minimize risk and maximize earnings, you should always undertake the full buffet of risk mitigation measures like diversifying your portfolio, investing according to your risk appetite and doing sufficient research.