Mutual Funds

What does a covered call strategy mean?

Satya Sontanam | Updated on October 04, 2020 Published on October 04, 2020

PPFAS Long Term Equity Fund will sell covered call options as part of investment strategy

Parag Parikh Long Term Equity Fund will write call options under a covered call strategy with effect from October 14, 2020.

If existing unit holders are not happy with this change, they can redeem or switch (to any other open-ended schemes of PPFAS Mutual Fund) at the prevailing NAV (Net Asset Value) without any exit load, on or before October 13, 2020.

What is covered call?

Covered call is an option strategy where a person writes (sells) call option on an asset she already holds. A call option gives the buyer the right but not the obligation to buy an asset on a certain date for a certain price.

The option buyer pays some amount — called option premium — to the option seller for the ‘right’ bought.

We recently explained how covered call strategy works in a video.

 

The call option will be exercised by the buyer only if the stock appreciates above the specified pre-defined price and not when the stock price falls or remains range-bound.

Thus, when the stock price falls, the downside to the option seller will be limited to the extent of premium collected. Further, if the market is range-bound, additional returns could be generated equivalent to the amount of premium collected.

However, there is a risk of high opportunity loss in case of appreciation in the stock price.

Because, as the stock price appreciates, the call writer is bound to sell the stock at the pre-defined price, irrespective of what the market price is.

Writing a call option on a particular stock in the portfolio depends on the fund managers’ view on the stock.

Note that mutual funds can write call options only on those stocks which are part of the Nifty 50 or the Sensex.

Rajeev Thakkar, CIO, PPFAS Mutual Fund, explains (on the fund house’s website) that the use of the strategy will be selective and will depend on the extent of mis-pricing/opportunity the fund sees in the options market.

Exit load

Generally, when there is a change in a mutual fund’s investing strategy, the existing unit holders will be given an option to exit.

In this case, you can redeem or switch (to any other open-ended schemes of PPFAS Mutual Fund) at the prevailing NAV (Net Asset Value) without any exit load on or before October 13.

Unit-holders who do not exercise the exit option on or before the said date are deemed to have consented to the proposed modification.

In case of exit, the redemption proceeds will be dispatched in 10 business days. In case of a switch, the proceeds can fully or partially be utilised to buy another scheme.

Note that the exit and switch options are available to unit-holders even after October 13, but there will be no exemption from the exit load — it is at 2 per cent or 1 per cent of the NAV if the investment is redeemed or switched on or before 365 days or 730 days, respectively, from the date of allotment of units.

Tax

Redemption or switch-out of units from any mutual fund scheme results in long/short-term capital gain/loss in the hands of unit-holders.

If you had invested in Parag Parikh’s Long Term Equity Fund before February 1, 2018, your cost of acquisition would be around ₹24.45 — the prevailing NAV on January 30, 2018 —the highest till then.

With inputs from Akhil Nallamuthu

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Published on October 04, 2020
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