What the Covered Call strategy in PPFAS’s fund means

By Morningstar |  21-09-20 | 
 

Covered call options are now permitted in Parag Parikh Long Term Equity Fund.

In the month of June 2020, the fund house saw certain unusually high Option prices in the market given the elevated volatility. Unfortunately, they were unable to use it to their advantage. Hence, the change in the offer document and the addendum.

The use of the strategy will be selective and depend on the extent of mis-pricing / opportunity in the Options market. Also, at times where the stock cash to futures arbitrage yields are zero to negative, this strategy may provide an alternative mechanism to deploy funds.

Covered calls can be written only on Nifty 50 / BSE Sensex 30 stocks. As per the August 2020 portfolio, they would be 7 stocks:

  • Axis Bank
  • Reddy’s Labs
  • HDFC Bank
  • Hero Motocorp
  • ICICI Bank
  • ITC
  • Sun Pharma

Of the above stocks, they cannot write Options on more than 30% of their portfolio holding in the above stocks. In other words, 70% or more of the holdings in the above stocks will be without any Options on them. And 100% of their investments in other stocks will be without any Options on them.

The total notional value of Options cannot exceed 15% of the equity value.

Kirtan Shah, a financial planner and options trader, explains what this is and shares his views.

How does a covered call work?

When a fund buys a stock, it does so with the expectation of the stock price going up. Should the stock stay sideways, the fund makes no returns. Worse still, if the price falls. This is where the covered call comes into play.

Let’s say PPFAS has invested in RIL at the market price of Rs 2,315. PPFAS will sell a call option of RIL at Rs 2,600 and receive a premium of Rs 10.

Selling a call option at Rs 2,600 indicates that the fund is not expecting RIL to move above Rs 2,600 in that month. 

Before we continue, do note:

  • Every derivative contract has an expiry date which is the last working Thursday of the month when the contract expires.
  • Rs 10 is the market-determined options price.
  • Theoretically, writing a call is a risk strategy, covered call (buy the share and then sell the call) has its own advantages.

What is the profit/loss that the fund incurs?

Situation 1 – PPFAS at an advantage

  • RIL closes the month at Rs 2,315
  • As the stock did not close above Rs 2,600, PPFAS will make Rs 10 as a profit
  • Other funds holding RIL make nothing

Situation 2 – PPFAS at an advantage

  • RIL closes the month at Rs 2,200
  • As the stock did not close above Rs 2,600, PPFAS will make Rs 10 as a profit
  • Other funds holding RIL will make a loss of Rs 115 (2315–2200 = 115)
  • PPFAS will lose Rs 105 (115–10 = 105) as it received Rs 10 as premium from the call option

Situation 3 – PPFAS at an advantage

  • RIL closes the month at Rs 2,600
  • As the stock did not close above Rs 2,600, PPFAS will make Rs 10 as a profit
  • Other funds holding RIL will make a profit of Rs 285 (2600–2315 = 285)
  • PPFAS will gain Rs 295 (285+10 = 295) as it received Rs 10 as premium from the call option

Situation 4 – PPFAS at a disadvantage

  • RIL closes the month at Rs 2,640
  • As the stock closed above Rs 2,600, PPFAS will lose Rs 30 (2640–2600 = 40)
  • The loss is Rs 40, but due to the Rs 10 as premium, net loss is Rs 30
  • Other funds holding RIL will make a profit of Rs 325 (2640–2315 = 325)
  • PPFAS will gain less, just Rs 295 (325-30 = 295)

What are the pros and cons?

The introduction of the 'covered call strategy' in the fund can be a game changer in a market that does not steeply go up or moves up gradually or stays sideways or even falls.

Going by the probabilities listed above, PPFAS does gain. It is a fairly obvious win-win situation.

The only deterrents are that the net asset value, or NAV, may get volatile due to the market-to-market impact. There could also be some opportunity cost loss, if after selling the call option in the interim the fund decides to sell the stock. If the fund size increases drastically, options may have an impact cost.

Will this restrict the upside that PPFAS can make on a stock?

This will not restrict the upside in the stock. It will generate income.

Worth mentioning is that there is absolutely no compulsion on the fund manager to use this strategy often. He might use it when he sees mispricing or does not expect stocks to move up.

Most importantly, he will use it when futures trade at a discount to the cash market and arbitrage can't be done.

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