The Securities and Exchange Board of India (SEBI) has introduced a covered call facility for mutual funds. This provision will allow mutual funds to generate some extra income on the securities they hold by selling call options on them. A call option is the right but not the obligation to buy a stock/index at a predetermined price.
What SEBI has allowed
Mutual Funds except Index Funds and ETFs may write call options on the constituent stocks of the Nifty 50 and BSE Sensex subject to the following:
1. The total notional value of the call option shall not exceed 15% of the total market value of equity shares held in the mutual fund scheme.
2. The total number of shares underlying the call option shall not exceed 30% of the unencumbered shares of a company held in the scheme. The unencumbered shares shall mean shares not held under the Securities Lending and Borrowing Mechanism (SLBM) or any other encumbrance.
3. If there is any passive breach of the above restrictions, the mutual fund will have to rebalance the portfolio with 7 trading days.
4. Funds cannot write call options without holding the underlying shares. These underlying shares should not have been already hedged under other derivative contracts.
5. The total gross exposure towards option premiums paid and received should not exceed 20% of the net assets of the scheme.
6.The call option shall be marked to market daily and reported in the NAV until the position is closed or expires.
You can get the detailed SEBI circular here.
How a covered call strategy works
The seller of a call option gets a fixed payment called a premium. In return he/she takes the risk of the actual price of the stock/index going far above the price determined in the call option (called strike price). In such a scenario, the seller of the call option has to bear the loss caused by this difference.
However if the seller of the call option holds the underlying stock/index in its portfolio, he will also make a profit on the underlying holdings even if he makes a loss on the call option. In such a scenario, the seller limits the loss on the call option but also caps his upside on the underlying holdings.
For example, if you hold 100 shares of Reliance Industries, currently trading at Rs 1,500 per share. You sell a call option on them at Rs 1,700 per share. If the price of Reliance Industries rises above Rs 1,700 you will make a loss on the call option but a profit on the underlying shares. Hence your gain on Reliance is capped at Rs 200 (1,700 – 1,500) until the call option expires or until you buy back the call option. If Reliance Industries falls below Rs 1,500 you will make a loss on the underlying shares but you will get to keep the call option premium. If Reliance Industries stays between Rs 1,500 and Rs 1,700 you will make a gain on the underlying shares and keep the call option premium. In this situation, you have the best of both worlds.