What is a fiduciary call? Understand here

What is a fiduciary call? Understand here

Mr. Deepak wants to buy 250 shares of Reliance Industries which is currently trading at ₹2,500. He has 2 options:

  • Option 1: Pay the full value of ₹6,25,000 and buy the shares in the cash market outright. Here, his returns will increase in value if the price of Reliance industries share increases and vice-versa.
  • Option 2: Use a fiduciary call.

In a fiduciary call, Mr.Deepak will spend ₹15,000 to buy a Reliance Industries call option and invest the rest of the money in a Fixed Deposit (FD) for 3 months @4% p.a.

Interest on FD is calculated on the principal amount invested 'P' for number of years 'N' at rate of return 'R' per annum.

As the duration of the FD is 3 months and not a complete year,the period 'N' will be represented as 3/12 and the rate of return 'R' will be represented as 4%.

FD Interest = P x N x R

100

= 6,10,000 x 3 x 4  = ₹6,100

100 x 12

Now if strike price < spot price at expiry, Mr. Deepak will redeem the money invested in the FD and use it to exercise the option. His earnings are the difference between the strike price and the market value of the shares minus the premium he paid for the call. Plus he also earns interest on the FD.

Total profit = [ {(spot price - strike price) x lot size }- premium paid + interest on FD ]

Now if strike price > spot price at expiry, Mr. Deepak will incur a loss on the options position to the extent of the premium paid. However the interest earned will offset a portion of this loss incurred.

Capital Balance =FD Investment + FD interest

=6,10,000 + 6,100 = ₹6,16,100.

Loss = Premium - FD interest = ₹15,000 - ₹6,100 = ₹8,900.

This strategy acts as a modified long position and helps Mr. Deepak reap the benefits of having a long position via options without investing his entire capital and limits his loss to the premium paid, which is also partly offset by the interest earned.

This is known as a fiduciary call.

Fiduciary call deposit refers to the money invested in a risk free investment avenue. In the above given example, it was ₹6,10,000 invested in fixed deposits. The money invested in fixed deposits is also an example of Fiduciary Money. Fiduciary money refers to the liquid capital accessible for use in the economy.

In the example, fixed deposit is an instrument on which risk-free, guaranteed interest can be earned. Alternatively, an investor may choose a very low-risk instrument like government bonds.

Fiduciary call and Protective put

Fiduciary calls and protective puts have similar payoffs. However, the key point of contention is that in protective puts, the investor already has a long position in the cash market and buys put options to hedge the downside risk . In fiduciary calls, the investor uses a small portion of his funds to take a long position in a call option while a large chunk of his funds are invested in risk-free, guaranteed interest financial instruments.

What is a protective put?

Let's understand this with the help of an example. Mr. Suraj already has shares of Reliance Industries worth ₹6,25,000 which are currently trading at ₹2,500. He feels that the share price will go higher in the long term, but could fall this month. So here he has 2 options:

  • Option 1:  Sell the shares in the cash market and buy the shares when the prices dip.
  • Option 2: Use a protective put strategy.

Here, Mr.Suraj will hold the shares and buy an OTM put option of strike price 2400 for a premium of ₹15,000.

At expiry, if the spot price falls below the strike price, he profits from the put option and his earnings are the difference between the current share price and strike price minus the premium paid.

Profit = [ {(strike price - spot price) x lot size } - premium paid  ]

However, at expiry, if the spot price is above the strike price, he will not exercise his option and will incur a loss in his put options position.

Loss = Premium paid = ₹15,000

Key considerations when using fiduciary call

  • Timing

The investor opting to go with a fiduciary call needs to bear in mind that the chosen risk-free investment should be liquid or it should mature on or before the contract expires. Like in the aforementioned example, if he is going for a fixed deposit of 3 months, he should ensure that the expiration date mentioned on the call options contract is 3 months from now or later.

  • Sufficient capital retention

The amount of an investor's risk-free and interest-bearing investment should cover the premium and contract value for the options or the investor may alternatively have some other capital available for this purpose.

  • Trading Expertise

Options are leveraged products. Additionally, even selection of strike price, calls for some amount of speculation, analysis and making stock market predictions. An investor needs to have a good understanding of the market and market forces to pull this off.

Benefits of using fiduciary call

  • Cost effective

As the investor does not hold any shares through the period up until expiry, he saves expenses such as that of additional brokerage fees and charges related to holding a large volume of shares.

  • Low upfront investment

As seen in the example, Mr.Deepek needs to make a much lower up-front investment with his fiduciary call.

  • Easy to navigate

Investors don't need to use special softwares or technology for a fiduciary call. It is also one of the easier options trading strategies that one can dabble with.

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