Allowing mutual funds to participate in the options market will bring more liquidity to stock options and stabilise returns for the fund
The Securities and Exchange Board of India (SEBI) has allowed mutual funds to write call options under a covered call strategy. The market regulator’s move will not only deepen the options market for single stocks, but also help fund managers to smoothen fluctuations in net asset values (NAV) and improve returns.
What is a covered call?
It is essentially an options strategy that involves both stocks and an options contract. There are two legs to this. First, a trader buys (or already owns) a stock. Second, she provides a cover against a fall in price, or a sideways movement in price, by selling a call option.
An illustration will help understand it better. Say, a mutual fund buys 250 shares of HDFC Bank which is trading at say Rs 2100. Now, if the fund manager feels that over the next one month the stock is unlikely to rise or may even fall he can protect his downside by selling out-of-the-money (OTM) options. Let’s assume that these options have a strike price of Rs 2160 and sold for Rs 30. Now, if the price of HDFC Bank stays at the same level (or falls), the fund manager is able to pocket the Rs 30, which becomes his profit (or reduces the impact of the loss from the fall in share price).
This particular call option will only lose money if HDFC Bank shares move up and close above Rs 2190 (2160+30) by expiry. In case the stock closes at Rs 2,200, the option with a strike price of 2160 would be worth Rs 40. So, the mutual fund manager would be incurring a loss of Rs 10. This loss can be settled in cash, or delivering the shares.
So how does allowing covered calls help fund managers? SEBI has allowed covered calls only in stocks that are part of the broad indices, which in any case account for a large portion of funds holding. Thanks to this move, fund managers can now hedge individual stocks that are vulnerable to event risks like earnings, elections, budget or credit policy. This way, if the long term story is intact, the fund manager need not sell the stock to capitalise for a short term blip.
In fact, covered calls will provide fund managers with the ability to earn extra from existing holdings. This way a fall in the stock, or the broader market, can be cushioned by locking the price through covered call hedges. The stocks already in possession with the fund can be used as margin which would mean a better return on investment (RoI).
Along with providing mutual funds with an important tool, SEBI’s move will bring in an important and big player in the options market, especially for stock options. Presently most of the volume in the options market is for index options, especially the weekly option. There is hardly any activity seen in stock options apart from a handful of stocks.
It will take a few months for activity in stock options to pick up, but SEBI should be applauded for this move since it benefits all stakeholders – mutual funds, investors, brokers, and traders.Not sure which mutual funds to buy? Download moneycontrol transact app to get personalised investment recommendations.