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Understanding MF’s Coverage Call Policy

A covered call option is an options strategy in which the person sells (sells) a call option on a stock that is already held in the portfolio. A call option seller (here a fund company) can generate income in the form of an option premium, which is paid by the option buyer.

“It is true that derivatives can be used for speculation, leverage and liquidation. However, derivatives can also be used to hedge and manage risk. Just as a kitchen knife can be used to stab people or cut fruits and vegetables, derivatives can also be used to Can be used for multiple purposes,” Rajeev Thakkar, CIO of PPFAS Mutual Funds, at Fund House Launches Calling Strategy Covered October 2020

Fund companies’ interest in covered call options has grown over the past year because the strategy allows fund managers to generate additional income, especially in falling or sideways markets. The latter refers to a phenomenon in which the stock market does not have a clear trend and is generally volatile.

Looking at the covered call trend, in June 2022, when the market was still under selling pressure, the PPFAS Flexi Cap Fund entered into 3,437 covered call contracts with a yield of rupee24.5 million for the month.This is compared to only nine contracts signed in May 2021, resulting in a net profit of only rupee35,291.

“The higher the volatility, the greater the return on the covered call,” said Feroze Azeez, deputy chief executive of Anand Rathi Wealth.

Although the PPFAS fund company’s gains in June 2022 are insignificant compared to its assets under management (AUM). rupee223 billion in the month, the fund company believes that in the long run, this will increase the fund’s income. This view is also echoed by DSP Mutual Fund, which recently used a covered call strategy in its Quant Fund.

“We are not even close to the allowable limit of covered call rights for our flexible cap fund. Also, the idea of ​​using the strategy is not to generate material gains, but to generate some additional returns that would not otherwise be available to us,” Raunak Onkar, head of research and co-fund manager at PPFAS MF, said.

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In addition, it is important to remember that the fund house’s use of a covered call strategy does not alter the planned investment and the basic style of building the portfolio.

how does this work

When a fund manager expects the price of any stock in the portfolio to fall or remain sideways in the short term, writing call options can help to earn additional returns while continuing to hold the stock.

For example, suppose Reliance Industries Ltd (RIL) is part of a planned portfolio purchased at current market prices rupee2,527.The fund manager believes the stock will not see any significant uptrend anytime soon and sells (sells) the monthly call option at the strike price rupee2,900.

Call option buyer gets “right” to buy stock rupeeThe expiration date is 2,900, regardless of the market price on that day.The option buyer pays a certain amount – the option premium rupee$5.50 per share – a “right” to the fund manager.

Let’s look at the gains or losses of mutual fund schemes under different market scenarios.

Scenario 1: When the market price on the expiry date is less than or equal to rupee2,900

The call option will not be exercised and the option premium is rupee 5.5 per share is the additional return for the fund. The fund manager continues to hold shares in RIL; the call option will only be exercised if the market price is higher than the strike price.

Scenario 2: When the market price on the expiry date is higher than rupee2,900.let’s put it in rupee3,000.

In this case, the call option is exercised – the fund manager must rupee2,900 to the option buyer.The actual profit and loss of the sale plan is (selling price minus cost price plus premium received) equal to rupee378.5 ( rupee2,900 – rupee2,527+ rupee5.5).

The plan has an opportunity loss in Scenario 2 – if the fund manager does not enter a covered call strategy, the stock can be rupee3,000 in the market, which results in capital gains rupee473 ( rupee3,000 – rupee2,527).difference rupee94.5 ( rupeeChapter 473—— rupee378.5) is the fund’s opportunity loss.

This happened in July in PPFAS’s Flexi Cap fund, where some of the Coal India shares owned by the scheme were sold as part of covered calls (albeit at a profit on the purchase price).

reduce risk

One of the risks of the covered call strategy is that it limits an investor’s ability to capture potential upside in the stock.

In the above example, any appreciation in RIL stock above the strike price is a loss of opportunity for the fund manager. However, experts believe that regulatory measures may limit the strategy’s unusual losses.

Covered call options can only be written on Nifty 50/BSE Sensex shares, according to market watchdog Sebi. Additionally, fund managers cannot hold options on more than 30% of any company held in the portfolio. In addition, the total notional value (strike and premium) of the call options held by the plan must not exceed 15% of the market value of the equity in the plan.

Fund houses said they also adhered to a number of internal measures to reduce the risk of accepting guaranteed subscriptions.

According to DSP Mutual Fund, “To reduce the risk of a covered call strategy, we will only write covered calls with strike prices approximately 5-10% above the current share price (we believe there are already 5-10% % uptrend) is unlikely to see overvalued stocks in the near term, which would benefit fund managers’ calls.”

The fund house also highlighted in its communication on its covered call strategy that it will issue calls with expiry in nearly a month rather than long-term options as uncertainty about further calls in the future increases. “We also avoided writing coverage calls in the face of overall macro uncertainty, such as an election with an unpredictable outcome.”

Onkar of the PPFAS Mutual Fund said: “We would never sell a covered call with a strike price below our purchase price.” In our example, rupee2,527 is the purchase price for Reliance; according to PPFAS, the strike price of the covered call will always be higher than rupee2,527. This is because even if the call option goes wrong and the stock has to be sold, the trade does not result in an actual loss of capital.

The fund house also said it would try to close out positions before expiration if it thinks covered call options are unfavorable to them.

meaningful impact?

“This strategy will definitely help to generate additional income, but it will only make sense if the program can make a call on a heavily held portfolio,” said Kirtan Shah, founder and CEO of Credence Wealth Advisors.

As the table shows, the AUMs of the PPFAS mutual funds disclosed by the fund companies are negligible. Furthermore, in this example, as highlighted in the table, under the assumption that this is true almost all the time, the additional income is only 0.8% of the total value of the fund per year.

Note that this is just an example, and it can vary widely by premium amount depending on different factors such as strike price, time period before maturity, volatility, corporate actions and earnings, and industry expectations.

On the other hand, if the call goes wrong, the opportunity cost of the scheme may be higher. “I’ve been doing phone writing for a while. We might be able to make 11 out of 12, but that one time the stock goes up, it’s probably taking away a good chunk of what you could have earned by holding the stock,” Shah added. road.

Most of the distributors and investment advisors Mint spoke with said they did not factor covered call strategies as a factor in analyzing funds because such strategies have no material impact on fund returns.

“In the case of covered calls, it is important for retail investors to understand to a large extent whether the fund company has communicated transparently about its use, rather than assessing the details of the covered calls taken by fund managers,” Shah added. road.

However, there does not appear to be uniformity among fund companies in terms of disclosure of covered calls entered within a month. PPFAS Mutual Fund has been providing detailed disclosures (as shown in the table) in all the people we checked and communicated to investors when calls go wrong (for example, the call to Coal India).

In addition to direct communication from the fund house, you will need to review the “Detailed Portfolio Disclosure” or fact sheet for details on the covered calls covered by the plan.

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