Choppy stocks, cloudy weather—how does one limit losses, protect capital and eke out some incremental gains in this market? Some fund managers have an answer: Covered call options.
A section of mutual funds is turning to a low-risk call options strategy to generate moderate returns and limit losses amid market turbulence. According to several mutual fund executives, arbitrage funds, equity savings funds and specialized investment funds (SIFs) are using this strategy when they expect stocks to decline or rise only a bit. The strategy, which involves buying stocks and selling call options on the underlying stocks, enables the fund to generate incremental returns and preserve capital in a volatile market.
"Arbitrage funds are increasingly adopting covered call strategies on both individual stocks and the index," said Laukik Bagwe, chief investment officer - SIF at ITI Mutual Fund. "At the moment, the objective is not to generate outsized returns but to preserve capital while earning incremental income," Bagwe added.
How it works
A fund manager buys a stock at ₹100 at the beginning of the month, and immediately sells someone the right -- a call option -- to buy it at ₹105 at the end of the month. The buyer gives the fund manager a fee - a premium - for this right. The fund manager keeps the premium, if the stock expires below or at ₹105.
If the stock drops to ₹95, the buyer won't exercise his right, and the call option expires worthless. Meanwhile, the fund manager limits his loss -- since he has already got a ₹2 premium, his actual loss will be ₹3. Without the covered call, the loss would have been ₹5.
If the stock rises modestly to ₹103, the option again expires worthless. The fund manger's total gain would be ₹5 -- the sum of ₹2 (the premium already received) plus ₹3 (the stock's appreciation)
The downside is capped profits. If the stock jumps to ₹110, the buyer exercises his option, and the fund manager has to sell the stock at the agreed price of ₹105, even though it's now worth ₹110.
Negative view
“We deploy covered call strategies as part of our portfolio. Naturally, we would use them more aggressively if we have a relatively negative view on the market," said Harish Krishnan, CIO, Aditya Birla Sun Life AMC Ltd. "Also, SIF are nascent category. As more funds are launched and managers observe what works over different market cycles, the adoption of different strategies will evolve," he added.
Mutual funds held pure equity and hybrid (equity and debt) assets worth ₹48.86 trillion as of June end, up 3% from February end, per Association of Mutual Funds in India (AMFI) data when the war began.
Prior to the war, the covered stock call outstanding net sale positions of domestic institutional investors (DIIs) rarely exceeded 300,000 contracts, shows NSE data. However, after it began, the outstanding net DII sales have since exceeded 400,000 contracts, rising to as much as 556,084 on 24 March, when the war was at its peak and the Nifty traded down almost 10% month-on-month at 22912. The outstanding sales stood at 433,542 contracts as of last Friday, with the Nifty down one fifth of a percent month-on -month at 23767, NSE data shows.
"So long as the geopolitical situation remains uncertain, such covered call strategies could continue, especially by SIFs, which have become active over the past few months, " said Nilesh Shah, managing director, Kotak Mahindra Asset Management Co.
Indian markets turned choppy since the war began on 28 February, with the Nifty having fallen 5.6% since the war began a day earlier through 23767 on Friday, per exchange data. This was primarily because Brent crude oil price surged 26% to $91.68 a barrel over the same period, as per investing.com.
A sustained rise in crude prices spooks India's macros and corporate profitability as the country imports about 85% of its daily crude and petro product consumption, said SK Joshi, former director (finance) at BPCL.