What is “covered call strategy” to be used by Parag Parikh Long Term Equity Fund

Published: September 15, 2020 at 11:20 am

Parag Parikh Long Term Equity Fund has issued a “change in the fundamental attribute” addendum to the scheme mandate including covered call options. In this article, we explain this strategy, why it is used and what investors should do when they receive such notifications from AMCs.

When we buy a stock or bond or any tradeable security we usually buy at market price. We can also enter into a contract with another party and buy or sell these securities at a pre-determined price. This kind of secondary product is known as a derivative. They are used as speculative products and for hedging risk (examples below).

Investors who had bothered to read the scheme document of Parag Parikh Long Term Equity Fund would not be so worried about this covered call option notice. The scheme document clearly states the following (page 28)

The Scheme may take derivatives position (in equity, currency and fixed income) based on the opportunities available subject to the guidelines issued by SEBI from time to time and in line with the investment objective of the Scheme. These may be taken to hedge the portfolio, re-balance the same or to undertake any other strategy as permitted under SEBI (MF) Regulations from time to time. The cumulative gross exposure through equity, debt, Foreign Equity and Derivative positions shall not exceed 100% of the net assets of the Scheme.
The Scheme may use derivatives for trading, hedging and portfolio balancing. Exposure to derivatives will be limited to 50% of the net asset value of the Scheme at the time of transaction. Exposure is calculated as a percentage of the notional value to the net assets of the Scheme. The Scheme will maintain cash or securities to cover exposure to derivatives.

In essence, the scheme had the freedom (past tense because of SEBI multicap ruling) to invest in ten different ways and now it has become eleven. Such notifications are mandated by SEBI with a 30-day exit load free window to exit the fund. AMCs should not simply thrust such notification to investors (most of whom never bother to read scheme material). Instead, they should first write a helpful article in their site, link to it on the fund page and in the email to investors to avoid unnecessary panic.

It appears as if mutual fund investors have only one foot inside the door all ready to leave if they see a notification that confuses them. That notification did have an example and it is easy enough to search what “covered call strategy” means online. Investors unwilling to do basic research in products where their money is already invested would find sticking to mutual funds hard. AMCs will make sort of changes – name, asset allocation, investing style, benchmark, strategy etc and investors will have to ready to research and decide each time.

What is a call option?

A call option is a derivative product. Let us say you buy a call option called ABC-30days-1000. This means you have the “option” to buy ABC stock at Rs. 1000 after 30 days.  This call option costs (premium) you Rs. 100 per stock.

After 30 days (expiry of the call option), the market price of ABC stock is Rs. 1200. You can exercise the call option and buy ABC at the predetermined price of Rs. 1000. Thus the profit per stock is Rs. 1200 – Rs. 1000 – Rs. 100 = Rs. 100.  If upon expiry, ABC trades at Rs. 1000 or lower, then you let the call option expire and the loss is just the premium of Rs. 100.

The exact opposite of a ‘call option’ is a ‘put option’ – the option to sell securities at a predetermined price. A call option is used to profit from a possible future price increase and a put option from a possible price decrease.

Suppose you hold ABC stock at Rs. 100 and expect the price to fall. You buy a put option for Rs. 90. Upon expiry, if ABC trades at Rs. 80, you can use the put option and sell at Rs. 90. Thus you have “hedged” your bet to an extent. If ABC trades above Rs. 90, you do not exercise the put and the cost of the put would be the loss.

What is a naked call option?

A person holding the call option speculates the price would increase in future. Suppose you are holding such a call option at Rs. 1000 and you feel the circumstances have changed. So you wish to sell the call option. Say Kumar by the call option from you for a small sum (premium).

On expiry, if the stock price is below Rs. 1000 then Kumar will not exercise the call option and the cost of the option – the premium – is your profit.  Suppose the stock trades at Rs. 1200 on expiry, you (call seller) will have to deliver the shares to Kumar (call buyer) at the option price of Rs. 1000.

Now suppose you never owned the stock all this time! To fulfil your obligation to Kumar, you have to buy the stock at market price (higher than before) and deliver at Rs. 1000. So you lose twice. Selling a call option without owning the corresponding shares is called a “naked call”. This is also called an “uncovered call” or a “short call”. Naturally, this is quite risky.

What is a covered call option?

By this time, you might have hopefully guess what is a covered call option. Selling a call option without holding the stock can be dangerous. So suppose when you sell the Rs. 1000 call option to Kumar, you also buy the stock at the market price of say Rs. 900. This is known as a covered call.

On expiry, if the stock price is below Rs. 1000 then Kumar will not exercise the call option and the cost of the option – the premium – is your profit. This is the same as above with a naked call. The fall in stock price is lowered to the extent of the premium. This is the downside protection referred to in the circular.

Suppose the stock trades at Rs. 1200 on expire, you (call seller) will have to deliver the shares to Kumar (call buyer) at the option price of Rs. 1000. You made a net profit of Rs. 100 on the shares (your buying price was Rs. 900) plus the cost of the call option that Kumar paid you.

However, if you did not exercise the call strategy your profit would have been Rs. 1200 – Rs. 900. In this simplistic example, the covered call strategy is profitable but in hindsight not as much as a simple buy and sell.

In general, if the stock price appreciates more than the option price + its premium, a covered call strategy would be less profitable but we will know this only on expiry. That is the nature of speculative trades and is riskier than simple buy/sell.

Thus the covered call option can be used to generate premium income if the sold call option is not exercised (stock price is below Rs. 1000 in the above example). This comes into play when stock prices neither move up nor down significantly. The PPFAS circular refers to this as a range-bound market.

In a covered call, you cannot sell the security until expiry and this make a portfolio of the portfolio illiquid. The option price will be marked to market like a bond price and it will reflect in the NAV and result in higher volatility when there is a supply-demand mismatch.

Thus the exposure should be limited. Covered calls can be made only with Nifty or Sensex stocks.  The total strike price + premium of the covered calls should not exceed 15% of total equity market value of the fund. Only 30% of shares not pledged or loaned can be part of covered call strategies.

What should investors do?

Instead of worrying about each notice they receive, they should take the time to understand the scheme document provisions and learn about the changes. As regards this current change, there is no need for investors to worry. They can stay invested in Parag Parikh Long Term Equity Fund.

It is plausible that the fund house wants to profit from a sideways market and lower risk. However, whether this strategy will make an observable difference or not will be hard to detect. It is arguable that this addendum was entirely unnecessary. It still could be, because of the SEBI’s multicap rules!

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