Understanding How a Fiduciary Call Works
Looking to protect your investments while still keeping your options open? That’s where a fiduciary call comes into play. A fiduciary call is a strategy used in options trading. Here’s how it works: you buy call options, which give you the right to buy something at a set price. At the same time, you put away the money needed for that purchase in a safe, interest-earning account. This method helps keep costs low and gives you a chance to make a good profit. Essentially, it’s a way to manage expenses while aiming for potential gains
It’s not just about minimizing risk—it’s about making informed decisions that can boost your returns. In this blog, we’ll break down the mechanics of a fiduciary call, complete with examples, formulas, and a comparison to protective puts.
After getting a glimpse of the strategy, let’s dive deeper and explore what a Fiduciary Call really is. Understanding its core concept will help you grasp how this approach can balance safety and growth in your investment portfolio.
What is a Fiduciary Call?
The term “fiduciary” implies a relationship based on trust and accountability. The beauty of fiduciary calls lies in their ability to provide an affordable way to gain exposure to the underlying asset. It also makes sure you have enough funds available to exercise the options if needed. By investing in a risk-free asset, you can also offset the impact of option premiums, which can otherwise be quite a burden. It’s like playing the stock market game with a clever, money-savvy twist.
When employing the fiduciary call strategy, a portion of an investor’s available capital is typically used to buy call options. The remaining funds are then invested in risk-free assets like money market instruments or fixed deposits. The interest generated by these risk-free assets, often characterized by minimal risk and steady returns, can help cover the costs of acquiring the call options.
For example, with ₹10,000, an investor might allocate ₹1,000 to buying call options and invest the remaining ₹9,000 in a money market fund or a fixed deposit. The interest earned from this risk-free investment can help offset the cost of the call options and enhance the overall profitability of the strategy.
Also Read: The Definitive Guide to Senior Secured Bonds: Safeguarding Investments with Tangible Assets
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How Are Fiduciary Calls Made?
In a fiduciary call, the investor assumes a fiduciary role by ensuring that the money invested in risk-free assets is readily accessible to cover the cost of exercising the call options when necessary.
This fiduciary duty aligns to manage assets in the investor’s best interest, ensuring they can exercise their options without facing undue financial hardship. To execute this strategy effectively, buying the call options and managing the risk-free investments must be done carefully and in balance. Investors must trust that their low-risk assets will yield enough returns to cover the call option expenses and provide further gains.
- Fiduciary Call Strategy
The fiduciary call strategy comprises two main components: buying call options and investing in risk-free assets. This division allows investors to benefit from the potential gains of the call options while also enjoying the security and income of low-risk investments. Their description and purposes are as follows:
| Component | Description | Purpose |
| Buying Call Options | Acquiring call options grants the right to purchase the underlying asset at a specified strike price. | To benefit from potential price increases of the underlying asset. |
| Investing in Risk-Free Assets | Investing in low-risk assets such as government bonds or savings accounts. | To provide security and generate income to offset the cost of call options. |
Also Read: RBI Floating Rate Bond: A Secure Investment Option
- Managing Risk by Generating Interest
Fiduciary call strategy has the ability to manage risk through interest generation. Risk-free assets, such as government securities and fixed deposits, accrue interest over time. This interest income helps cover the cost of the call options, thus reducing the net expense and overall risk associated with the strategy.
For instance, if an investor invests in a fixed deposit yielding 3% interest and buys ₹1,000 worth of call options with a ₹1,000 premium, the interest earned can partially offset the option premium. This arrangement assists in cost management and serves as a safety net if the options are not exercised.
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Now that you know how Fiduciary Calls are made, let’s look at a real-world example to see how this strategy works in practice. This will give you a clearer picture of how combining secure investments with call options can play out in different market scenarios.
Example of a Fiduciary Call
Suppose an investor who prefers to use only some of their available funds to purchase a specific stock directly but still wants exposure. Instead, they invest the remaining money in a risk-free, interest-bearing account and buy call options on the stock. This strategy allows the investor to leverage their investment and better manage costs.
Scenario Description
An investor with ₹10,000 decides to implement a fiduciary call strategy. They allocate ₹1,000 to purchase a call option on a stock with a strike price of ₹100. The remaining ₹9,000 is invested in a fixed deposit earning 3% annual interest.
Calculation of Fixed Deposit Interest
- Principal Amount: ₹9,000
- Annual Interest Rate: 3%
- Interest Earned: ₹9,000 * 3% = ₹270 per year
Profit and Loss Scenarios
- If the Stock Price Rises
If the stock price rises to ₹120 at expiration, the investor can buy the stock at the ₹100 strike price. The profit is calculated by subtracting the premium paid and adding the interest earned. For instance, if the options allow the purchase of 100 shares:
- Gain = (120 – 100) × 100 – 1,000 + 270
- Profit = 2,000 – 1,000 + 270 = 1,270
Including interest income, the overall profit in this scenario would be ₹1,270.
- If there is a Decline or Stability in the Stock Price
If the stock price drops to ₹90 or remains at ₹100, the call options will expire worthless. The premium paid would be forfeited, but the interest on the fixed deposit would offset a portion of this loss:
- Loss = 1,000 – 270 = 730
Considering interest income, the loss in this case would be ₹730.
Also Read: SIP vs. FD – Understanding Differences for Investments
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Formula for Calculating Profit or Loss
Elements That Make Up the Formula
- Option Premium: The amount paid upfront for the call options, granting the right to purchase the underlying asset at the strike price.
- Interest from Risk-Free Investments: Money received from holding risk-free investments, such as government bonds or fixed deposits. This interest helps offset the option premium, lowering the overall cost of the strategy.
- Stock Price at Expiry: The price of the underlying stock at the expiration date of the call option. It determines whether the option will be exercised.
- Strike Price: This is the fixed price at which the holder of the call option can purchase the underlying asset. The strike price is agreed upon when the contract is created.
Formula
Profit/Loss = (Stock Price at Expiry – Strike Price) – Option Premium + Fixed Deposit Interest
Also Read: Biggest Stock Market Crashes in India: Lessons from the Past
Example 1: If the Stock Price at Expiry Is Higher Than the Strike Price
- Paid premium: The investor initially pays ₹1,000 as a premium to buy the call option.
- Earned Interest: The investor earns ₹270 as interest from their risk-free investment.
- Stock Price at Expiry: At expiration, the stock price rises to ₹120, which is above the strike price of ₹100.
The profit calculation:
- The investor gains from the option: (120−100) × 100 = ₹2,000
- Subtract the premium paid: ₹2,000 − ₹1,000 = ₹1,000
- Add the interest earned: ₹1,000 + ₹270 = ₹1,270
Example 2
When the Stock Price Hits the Strike Price or Expires Below It
- Paid premium: The investor initially pays a premium of ₹1,000 to purchase the call option.
- Interest accumulated: Over time, the investor earns ₹270 as interest from the risk-free investment.
- Stock price at expiration: At expiration, the stock price is ₹90, which is below the strike price of ₹100, making the option unprofitable to exercise.
The loss calculation:
- The investor starts with a premium expense of ₹1,000.
- They earn ₹270 as interest.
- The net loss is calculated by subtracting the interest earned from the premium paid: ₹1,000 (premium) – ₹270 (interest) = ₹730.
Considering the interest income, the loss in this case would be ₹730.
Following the examples, it’s crucial to examine how interest from fixed deposits affects the overall profitability of the fiduciary call strategy. This will offer insights into the financial impact of the strategy’s components.
Advantages of Making a Fiduciary Call
- Cost Efficiency
The fiduciary call strategy is cost-effective because the interest received from risk-free investments partially offsets the call option premiums. Consequently, the plan’s overall cost is reduced, making it appealing to investors seeking to manage their expenses effectively.
Also Read: Tax Efficiency: The Cost Inflation Index
- Reduced Initial Outlay of Funds
A fiduciary call requires a smaller initial investment than buying the underlying stock outright. The investor only needs to pay the call options premium, with the remaining funds invested in low-risk securities. This approach minimizes the capital invested while maximizing the stock’s potential upside.
- Reducing Risk
The fiduciary call strategy lowers risk by combining risk-free investments with call options. The interest earned from risk-free assets helps cover the option expenses, providing a safety net against adverse changes in the stock price.
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Understanding the benefits sets the stage for discussing practical considerations. Factors such as timing, market knowledge, and capital management are critical to successfully implementing a fiduciary call strategy.
Considerations for a Fiduciary Call
- Arrangement and Disposition
Timing is essential for the fiduciary call strategy to work effectively. The investor must ensure that the expected date of the option exercise aligns with the maturity of risk-free investments. Additionally, the liquidity of the risk-free assets must be considered to guarantee that funds will be available when needed.
- Market Knowledge and Proficiency
Implementing a fiduciary call strategy requires thoroughly understanding options trading and current market conditions. Investors should be capable of assessing potential outcomes and making informed decisions. Staying aware of market trends and option pricing is essential for managing the strategy effectively.
Also Read: Differentiating Primary and Secondary Markets
- Management and Retention of Capital
Effective capital management is crucial for fiduciary call strategies. The investor must ensure sufficient cash is available to cover any necessary call option exercises. This requires careful planning and monitoring of investments to maintain the necessary liquidity and avoid potential issues.
It’s also essential to compare the fiduciary call with the protective put strategy. This comparison will provide a comprehensive view of their relative strengths and applications in risk management.
Fiduciary Call vs. Protective Put
The comparison between Fiduciary Call and Protective Put are as follows:
| Aspect | Fiduciary Call | Protective Put |
| Objective | Manages risk by leveraging call options and reducing their cost. | Protects against losses by owning the underlying stock and using put options. |
| Execution | Purchase call optionsAllocate funds to low-risk investments | Own the underlying stockAcquire put options as insurance |
| Risk Management | Uses interest from safe investments to offset the cost of call options. | Put options provide a predefined selling price to limit losses. |
| Profit Opportunity | Profits from the rise in the underlying asset’s price. | Limited loss potential due to the insurance provided by the put option. |
| Cost Management | Interest income from low-risk investments helps manage the cost of options. | Cost of put options is an additional expense. |
Also Read: Debentures vs. Bonds: A Clear Guide for Informed Investors
Conclusion
The main goal of a Fiduciary Call is for you to balance safety and growth by mixing secure investments with the potential gains of call options. By doing this, you can earn steady interest from low-risk assets while also having the chance for higher returns if the market moves in your favor.
These strategies work best if you understand how options trading and the market work. Although they offer you a safer and more cost-effective way to trade options, they require careful planning and smart use of your money. This method is especially useful if you want to benefit from a potential price increase without putting too much of your money directly into the asset. The aim is to combine the security and income from safe investments with the growth opportunities of call options.
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