What Is a Fiduciary Call? Learn How It Works

Several call option strategies are prevalent among traders and investors who want to hedge or reduce their risk of losses in unfavourable market conditions. Fiduciary call options are one such approach where a call option buyer can hedge the risk involved in their investment by using risk-free financial instruments. As the returns on such investments are guaranteed and stable, an investor can reduce their costs.

The following sections will cover everything you want to know about this trading strategy.

What Is the Meaning of a Fiduciary call?

A fiduciary call is an options trading strategy or an approach implemented by an investor to reduce the cost of exercising a call option. In this strategy, an investor uses a part of their available funds to purchase a call option and invests the rest in a risk-free asset like fixed deposits or money market instruments.

An investor invests a small portion of their fund to take a long position i.e. when an investor estimates that the stock price will go up. While on the other hand, a large chunk of these funds is invested in a risk-free instrument with a guaranteed instrument.

Let’s understand the concept of fiduciary call options with an example:

Understanding How Fiduciary Call Works with Example

Mr Arjun is planning to invest in 500 shares of ITC limited which is currently trading at ₹387. He has two options to do so. 

He can purchase 500 ITC shares in full worth ₹1,93,500 from the stock market. Therefore, his returns will increase if the stock price of ITC Ltd increases and vice versa. Alternatively, he can implement the fiduciary call strategy.

In the fiduciary call strategy, Mr Arjun will have to spend ₹5,000 in premiums to purchase a single lot of ITC Ltd call option. He will invest the rest of his funds (₹1,93,500-₹5,000= ₹1,88,500) in a fixed deposit for 3 months with an annual interest of 5% p.a.

In this fixed deposit, interest will be calculated on the principal amount (P) i.e. ₹1,88,500 for a certain number of years (N) at the rate of Interest(R) per annum.

Here the duration is 3 months. Therefore “N” will be 3/12 and the rate of interest “R” will be represented as 5%.

The interest of fixed deposit (without compounding) will be calculated as = P x N x R / 100

Therefore,

(1,88,500*3*5)/12*100= ₹2,356.25

Suppose the current market price (spot price) of ITC is greater than the option’s strike price when it expires. Mr Arjun will redeem the amount of FD investment and use it to exercise this option. Therefore, profits earned by Mr Arjun will be the difference between the spot price and strike price followed by the deduction of the premium and addition of the FD interest.

Total profits earned via fiduciary call = [{(spot price – strike price) x lot size} – premium paid + FD Interest]

If the spot price of ITC Ltd is ₹400, his profits will be:

Profits = {(400 – 387) x 500)} + 2,356.25 – 5,000 = ₹3,865.25

Now let us say that the opposite thing happens, i.e., the strike price is less than the spot price. In that case, Mr Arjun will have to incur a loss on the option position up to the extent of the premium paid.

In such a scenario, his losses will be:

Total Loss Incurred = Premium – interest 

₹5,000- ₹2,356= ₹2,644

Therefore, this fiduciary call approach helped Mr Arjun in reducing the losses from his long position by partially offsetting the premium loss with interest from a fixed deposit.

Pros of Using a Fiduciary Call

The following are the advantages of using fiduciary calls:

• Cost Effective

Fiduciary calls are cost-effective as investors do not have to pay extra brokerage charges.

• Low Upfront Investment 

To lock your desired buying price, you are not required to invest considerable funds for purchasing a huge number of shares upfront. 

• Easy Navigation

There is no requirement for special software or technologies to be known by the investors.

Protective Put and Fiduciary Call: The Difference

The payoffs for a protective put and a fiduciary call are almost very similar. In a protective put option, the investor already has a long position in the cash market and also purchases a put option to hedge the risk of a stock price crash. 

On the other hand, a fiduciary call is an approach where an investor utilises a small portion of their funds to take a long position while investing the remaining major chunk in risk-free financial instruments. Here, the investor gets a guaranteed return on investments.

Points to Consider While Using Fiduciary Calls

Before using a fiduciary call, refer to the following things:

• Timing

Timing for the investment in risk-free investment should be liquidated before the expiry date. For Instance, in the example of Arjun, He invested in an FD which had a maturity of 3 months which was before call expiry.

• Trading Expertise

As an investor, you need to have the expertise and a good understanding of the market. Selection of a strike price, analysis and understanding of the market is essential to reduce the loss probability.

• Good Capital Retention

The amount of investment in risk-free financial instruments should be in such a proportion so that the income it generates will be able to partly cover the amount of premium.

Final Words

As an investor, you should make sure that the dates of maturity of the risk-free investment account should exactly match the expiry date of the call option.

Even though, you as an investor implement a fiduciary call approach as a strategy to hedge or minimise the risk and maximise your profits. You should always consider proper diversification of your portfolio. Invest only in those stocks on which you have carried out sufficient research and as per your risk appetite.

Frequently Asked Questions