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It is a common principle in the stock market that higher risk dictates higher rewards as the volatility increases, leading to bigger price swings and higher profits. Investors who have a higher risk tolerance find investment instruments with higher risk and volatility to achieve their goals of earning higher profits. However, investors with a lower risk tolerance generally have to settle for lower returns as they prioritise taking on low risk rather than earning higher returns. Experienced investors with extensive investing knowledge utilise various investment instruments to ensure they capitalise on their features and can earn higher returns in a specific investment instrument by using the returns of another low-risk and steady-return investment instrument.
Key Takeaways
- A fiduciary call is an options trading strategy that aims to mirror the returns of an underlying asset without directly buying it.
- It includes investing in a call option with the same underlying asset and investing the remaining amount in a risk-free investment that pays regular interest.
- A fiduciary call significantly minimises the risk while maintaining the same profit potential as buying the underlying asset directly.
If you are an investor and want to earn high returns, a fiduciary call can help you combine the returns of two investment instruments to significantly lower the overall risk. This blog will help you understand all about a fiduciary call and how it can help you earn better returns while taking on lower risk.
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What is a fiduciary call?
What is a fiduciary call?
A fiduciary call is an options strategy that involves buying a call option and simultaneously investing in risk-free assets, like Treasury bills or Fixed Deposits, equal to the strike price. A fiduciary call is the same as buying a regular call option, with a variation that the current value of the strike price is invested in another investment instrument that provides regular interest with the lowest possible risk. For example, you can buy a call option and invest the remaining money (which you have otherwise invested if you have directly bought the shares in the stock market) in an FD and use the final redemption amount from the FD to exercise the call option.
The main aim of a fiduciary call is to lower the risk associated with buying the call option by guaranteeing returns from another interest-bearing investment instrument.
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How fiduciary call works?
When options traders want to buy a call option, they have the right to buy the asset at a specific strike price before the option expires. However, to exercise the option, the trader has to pay the seller a premium, which can decrease the returns and increase the risk as the option nears expiry. A fiduciary call works by combining the purchase of a call option and an investment in a risk-free, interest-bearing investment instrument to mirror the payoff of owning the underlying asset.
There are two components in a fiduciary call:
- Call option: This gives the investor the right, but not the obligation, to buy the underlying asset at a specified strike price before or at expiration.
- Interest-bearing investment: This investment usually involves risk-free interest-bearing investment instruments such as FD or government bonds to match the call option's strike price.
In a fiduciary call, an investor purchases a call option for a specific underlying asset and simultaneously invests an amount equal to the call option's strike price in a risk-free, interest-bearing investment instrument. This investment grows at a risk-free rate and is meant to cover the strike price if the option is exercised.
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Benefits of using a fiduciary call
Here are the benefits of using a fiduciary call while buying a call option:
- Limited risk: A fiduciary call limits the risk to the initial investment and the call option's cost through the risk-free asset investment. If the call option’s strike price is favourable at expiry, the investors can earn good returns while limiting the loss potential.
- Lower investment: Investors using a fiduciary call can mirror the benefits of owning the underlying asset without actually having to spend the required money to buy the underlying asset.
- Fixed cost: Using a fiduciary call, investors limit their maximum loss to the cost of the call option and the difference between the invested amount and the actual strike price. This ensures that they know how much loss they stand to make.
- Interest income: Although the investment in the risk-free interest-bearing investment instrument is to match the strike price of the underlying asset, it can provide interest income in case the investors decide not to exercise the call option.
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Choosing the right fiduciary call for your needs
A fiduciary call is the combination of a call option and investment in a risk-free, interest-bearing investment instrument. However, it is important to choose the right combination to create an ideal fiduciary call. Here are some factors to consider:
- Strike price: The strike price you choose for your call option should align with your target price for the underlying asset.
- Expiry: It is important that you choose the expiration date for your call option based on your time horizon.
- Option premium: You should ensure that the call option’s premium is ideal and is at par with your expected return.
- Risk-free investment: To maximise the interest payment, you should choose the risk-free investment with the lowest risk and the highest interest rate.
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Conclusion
Investing directly to buy an underlying asset can prove to be risky and require a high initial investment. Investors can use a fiduciary call to combine the purchase of a call option in the same underlying asset and invest the remaining amount in a risk-free interest-bearing investment instrument. A fiduciary call can help investors mirror the potential returns of directly investing in the underlying asset through a call option and risk-free investment instrument to significantly lower the overall risk.
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Frequently Asked Questions
Fiduciary call
What are the key responsibilities in a fiduciary call?
How does a fiduciary call differ from other financial services?
A fiduciary call mimics owning an asset by combining a call option with a risk-free investment, while other financial services may offer different investment or advisory options without this specific investment combination.
Who can benefit from a fiduciary call?
Investors who want to benefit from an asset’s price increase without actually buying it can use a fiduciary call. It’s good for those wanting to limit their risk while still wanting to earn profits.
What factors should be considered when selecting a fiduciary?
You should consider the strike price of the call option, its expiration date, premium amount and the type of risk-free investment instrument.
Disclaimer
Standard Disclaimer
Investments in the securities market are subject to market risk, read all related documents carefully before investing.
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