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Options trading is a clever tool traders use to get more out of their market trading. And among the different strategies in options trading, there’s one called the “fiduciary call strategy.” It’s a smart way to trade that helps you handle risks while having a chance to make some gains.
What is a fiduciary call?
The fiduciary call strategy involves two primary components: buying a call option and simultaneously setting aside enough cash to cover the potential exercise of that option. This approach is rooted in risk management and serves as a protective measure to limit potential losses.
Fiduciary call example
An investor is looking to purchase 100 shares of ABC Corporation. Its share is trading at Rs.500 per share at the moment. The investor believes that the stock has the potential to appreciate shortly but is concerned about short-term market fluctuations.
To protect against potential downside risk while participating in any price appreciation, the investor decides to execute a fiduciary call strategy.
The investor buys a call for 100 shares of ABC Corporation. The strike price is at Rs.550 per share. Simultaneously, the investor invests an equivalent amount of money in a risk-free asset, such as a government bond or a fixed deposit with a face value of Rs.55,000 (100 shares x Rs.550 per share).
The investor has created a protective position using the fiduciary call deposit strategy.
Imagine a situation where the price of ABC Corporation’s stock price rises above Rs.550 on or before expiry. The investor can then exercise the option at the strike price and buy the shares at a lower price, realising a profit.
On the other hand, if the stock’s price falls or remains below Rs.550 per share, the investor’s loss is limited to the premium paid for the call option, as the risk-free bond investment serves as a hedge.
Fiduciary call formula
The formula for calculating the profit or loss from a fiduciary call position depends on the specific details of the call option and the risk-free asset involved.
Here is a formula to calculate the return from a fiduciary call:
Profit/ loss = (stock price at expiration – strike price of call option) – premium paid for call option + interest earned from risk-free asset
In this formula:
The stock price at expiration is the price of the underlying stock at the expiration date of the call option.
The strike price of the call option is the price at which the investor has the right to buy the stock.
The premium paid-for-a-call option is the cost of buying the call option.
Interest earned from a risk-free asset is the interest income earned from the risk-free asset over the same period.
Fiduciary call and protective put
A fiduciary call and a protective put are two distinct strategies, but they share similarities in their risk management objectives. Both strategies aim to protect an investor’s capital while allowing them to participate in potential price gains.
A protective put strategy entails purchasing a put option for a stock that an investor currently holds in their portfolio. This put option grants the trader the right to sell the stock at the strike price, offering a safeguard against potential losses, in case the stock’s value declines.
In exchange for this protection, the investor incurs a premium cost for the put option similar to the premium paid for a call option in a fiduciary call approach.
The difference between a fiduciary call and a protective put is in the choice of options:
- In a fiduciary call, an investor buys a call option and invests in a risk-free asset.
- In the protective put strategy, a trader buys a put option on a share they already own.
- Both strategies protect against downside risk, but the fiduciary call allows investors to maintain exposure to an asset they do not own.
Advantages of using the fiduciary call strategy:
Saves money
When you use the fiduciary call strategy, you do not have to buy any shares until the contract ends. This means you will not be losing before you know the strategy’s outcome.
Lower starting cost
Starting the fiduciary call strategy requires less money upfront compared to other methods.
Easy to use
You don’t need fancy software or complicated technology for fiduciary call strategies. They’re simple and accessible for regular investors. It’s a simple choice for fresh traders and investors who want to try their hand at options trading.
Conclusion
A fiduciary call is a powerful tool that allows investors to protect their capital while participating in the potential upside of an asset. By combining call options with risk-free assets, investors can manage risk effectively and make informed investment decisions.
Understanding the concept of fiduciary call is essential as these strategies can help individuals and institutions alike achieve their financial goals while minimising risks in an ever-changing market environment.
FAQs
A fiduciary call is a strategy combining a call option and a risk-free interest-bearing account. The payoff at expiration is the strike price when the call is out-of-the-money, and the strike price plus the difference between the stock price and the strike price (i.e., the stock price) when the call is in-the-money. This strategy can lower the costs inherent in exercising a call option.
The Put-Call Open Interest (OI) Ratio is a market sentiment indicator used by investors. It’s calculated by dividing the total number of open interest put options by the total number of open interest call options. A ratio greater than 1 suggests a bearish market (more puts than calls), while a ratio less than 1 indicates a bullish market (more calls than puts)1. It helps gauge market mood before a turn.
A covered call is an options strategy that involves holding a long position in an underlying asset (like a stock) and selling (writing) call options on that same asset. This strategy is used by investors who believe the asset will experience minor price fluctuations. The investor sells call options to generate income, while the long position in the asset acts as a cover. However, the investor forfeits stock gains if the price moves above the option’s strike price.
The Out of The Money (OTM) Call Ratio is typically used in a Call Ratio Spread strategy. This strategy involves buying one at-the-money (ATM) or OTM call option and selling two call options that are further OTM. This is commonly referred to as a one-by-two ratio (1:2). The OTM Call Ratio is crucial in determining the risk and potential return of the strategy.
Delta in options trading is a risk metric that estimates the change in the price of an option for every ₹1 move in the underlying asset. It’s represented by the symbol Δ. Delta can be positive or negative, being between 0 and 1 for a call option and -1 to 0 for a put option. It helps traders understand the cost of taking directional exposure in a stock.
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