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CM Strategy

Trading the Reliance Rights Issue Like an Option

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The Reliance Rights issue Opened today, we’ve written earlier about it here

We did a super interesting #experimental trade on the Rights Issue which is listed separately on the exchange as RIL-RE-BE, which is a first of a kind listing, on a new platform introduced by NSE for such offers.

If you think about it, the RIL-RE-BE is a rights entitlement security. Buying it gives you the right to pay Rs. 314.25 and buy a Reliance Partly Paid Share.  The partly paid share itself requires a payment of Rs. 942.75 but they are clearly going to ask for it only one year later. 

Effectively, you pay Rs. 314.25 + (Price of RIL-RE-BE) to get this partly paid share.

The partly paid share is similar to a stock option. Meaning, you have the right (but not the obligation) to pay Rs. 942.75 next year, so as to get a full Reliance Share then. That means, you can look at the partly paid share as if it was a long term in-the-money option. 

The trade is 

Trading the Reliance Rights Issue Like an Option

At this point Reliance is at 1433 per share. 

Note – This trade was initiated on 20th May’20 with an expected return of 4% on the capital deployed, at the time of publishing this post the trade has already done upwards of 2%. Do factor this in, if you are considering an entry today. Beyond which the downside risk increases, as you would lose out on two days worth of decay on the short call.

There are two ways to look at this trade, either as a Covered call or a Calendar spread 

First lets compare it with a regular covered call

A regular covered call would have meant, we buy Reliance Shares

Trading the Reliance Rights Issue Like an Option

Now three scenarios are possible 

Scenario 1:  Reliance goes down

You make a profit on the short call because the call options don’t get exercised and you earn the premium. But you make losses on the stock.

If the stock goes down a little, your losses on the stock are offset by the premium received. If it goes down a lot, then you lose more.

Scenario 2:  Reliance stays range bound

You make a profit on the short call because the call options don’t get exercised and you earn the premium. You make neither losses nor profits on the Reliance shares.

Scenario 3:  Reliance Rockets Up

Till 1400, you make no losses. But if Reliance breaks out and moves up around 10%, in a covered call scenario, You gain on shares but lose on short call, net net no losses through.

That’s how a traditional covered call would do. 

Now you’ve got a listed Entitlement Scrip (RIL-RE-BE) instead, which has the delta of 1 i.e similar to holding Reliance Shares.So the behaviour of the trade outcome, stays the same except for the fact that you are not paying as much as you would for the Reliance Shares. 

Pricing the entitlement as a Longer Term Call Option

We can look at the entitlement as a LEAP Call with 1 year to expire, at the strike price 950 (1257 – 314.25 = 942.75)* refer to the previous post for specifics on the rights pricing.  If you use a Black & Scholes calculator you would arrive almost at the same price.

Right now the entitlement is priced at 314.25 + 200 = 514.25 and as you can see below an hypothetical reliance LEAP would be priced the same. 

Trading the Reliance Rights Issue Like an Option

  Calculated by using Zerodha’s – Black & Scholes Option Pricing Calculator

 

How Does The Trade Work?

Remember this: The Reliance share is at Rs. 1433. Effectively the price you pay for the RIL-RE-BE should somehow link to this price, because eventually the rights will convert to this share. 

So it will be priced like this:

RIL-RE-BE price = Reliance Price – (942.75 payable a year later + 314.25 payable now) + some extra volatility premium. 

Mathematically:

RIL-RE-BE price = Reliance price – 1257 + vol premium also known as the “time value”.

At the current price of 1433, the RIL-RE-BE price should be Rs. 176. It’s trading at Rs. 199. So you are paying a “time value” of Rs. 23 for it.

The other side of the trade is to sell the 1400 Call (June Expiry) for Rs. 99. That has a time value of Rs. 66 (1400+99-1433).

The two are like an arbitrage – In one case you have a time value of Rs. 23 for one year. In the other, you have a time value of Rs. 66 for one month.

The trade intends to bridge the gap. As the days pass, the time value of the June expiry call should drop fast, while the RIL-RE will retain value for longer. The difference of Rs. 43 between the two is an opportunity. 

What are the Risks?

If Reliance falls below 1400 this could lose money. This will need the 1400 call to be switched downwards to say the 1350 or 1300 calls. The risk is all on the downside.

Another risk is that we have to close out this trade in about a week, because the RE share will stop trading after June 1. There could be some crazy volatility that beats us up.

Reward: If we target Rs. 20 per share, that’s a return of Rs. 10,000 on an investment of roughly Rs. 2.5 lakh. It looks attractive for a week’s exposure. 

How does all this help?

Well essentially you have a low cost way to get an exposure to Reliance on the long side, with that set, you can design any strategy around it. Covered Calls or Calendar Spreads, both of which should give you returns upwards of 4% a month on this trade. 

You could turn that around every month, and as long as Reliance retains a value above 1257, the trade could keep working our favour. 

 

This will be tracked on Slack in #experimentals and #experimental-action 

 

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