hello world!

Options: The Concept of Put-Call Parity

Sebencapital

Published
22/12/23
Options: The Concept of Put-Call Parity

Options, which are financial tools, can be compared to a chess game due to their complexity and various possibilities throughout their lifespan. When dealing with options, there are numerous chances that can either boost or diminish the value of your position.

Options trading involves several factors influencing the prices. The prices of options can change based on factors like implied volatility shifts, alterations in supply and demand for options, causing their premiums to fluctuate.

Understanding put-call parity is crucial in options trading. Explore more about this concept and how it operates to make informed decisions in trading.

Key Takeaways

  • Put-call parity is the principle where the worth of a put option equals that of a call option under certain conditions.
  • The options share identical strike prices and expiration dates.
  • Knowing about put-call mispricing improves your chances of succeeding in the market.

What Is Put-Call Parity?

Put-call parity is a crucial concept in the world of options trading. It’s about the equal value between put and call options. With put-call parity, you can calculate the value of a call option by knowing the value of a put option with the same strike price and expiration date. This understanding is valuable because it helps identify profitable opportunities when option prices aren't aligned correctly. It also assists in assessing an option's relative value.

Options come in two styles: American and European. American options can be exercised anytime, while European options are only exercised at expiration. Put-call parity tends to work more accurately with European-style options.

What Are Examples of Put-Call Parity?

An option's price has two parts: intrinsic value and time value. Intrinsic value is the amount that an option is already profitable if it were exercised right away. For instance, if you have a call option to buy silver at ₹15 when the current price is ₹16, the ₹1 of value is the intrinsic value. The rest of the premium, like the extra 50 cents if the total premium is ₹1.50, is the time value.

Note

Time value is the portion of an option's worth that is solely related to the time remaining before the option expires.

Consider a ₹17 call option on silver when the market price of silver is ₹16. In this scenario, the option doesn't possess any intrinsic value as the market price is below the strike price. The option's entire value, therefore, consists of 50 cents representing its time value. In essence, options that are in-the-money include both intrinsic and time value, while out-of-the-money options only contain time value.

Put-call parity extends from these basic concepts. For instance, if gold trades at ₹1,200 per ounce in June, a ₹1,100 call option with a premium of ₹140 would have ₹100 of intrinsic value and ₹40 of time value. According to put-call parity, the value of the June ₹1,100 put option will also be ₹40.

In another scenario, if cocoa is trading at ₹3,000 per ton in July, a July ₹3,300 put option with a premium of ₹325 per ton indicates that the July ₹3,300 call option is valued at ₹25 per ton. Notably, at-the-money call and put options with the same expiration and strike price (known as straddles) will trade at an equivalent price as both solely contain time value.

What Are the Formulas?

To summarize, here are some straightforward formulas for European style options:

  • Long Call + Short Future = Long Put (same strike price and expiration)
  • Long Put + Long Future = Long Call (same strike price and expiration)
  • Long Call + Short Put = Long Future (same strike price and expiration)
  • Long Put + Short Call = Short Future (same strike price and expiration)

These are positions called synthetic positions. They are made by bringing together the necessary options and futures that have the same expiration date and, for the options, the same strike prices.

The Bottom Line

Options are fascinating tools. When you grasp the concepts of options and put-call parity, it can boost your understanding of the market. This knowledge can lead to better ways of managing risks and finding profitable opportunities.

Put-call parity isn't limited to specific markets; it applies across various assets where options are traded. Taking the time to comprehend put-call parity can provide you with an advantage in understanding markets, giving you an edge compared to many other traders.

Success in markets often stems from spotting market differences or mispricings before others. The more you learn about these concepts, the better your chances of success in trading.

Written by Sauravsingh

Techpreneur and adept trader, Sauravsingh Tomar seamlessly blends the worlds of technology and finance. With rich experience in Forex and Stock markets, he's not only a trading maven but also a pioneer in innovative digital solutions. Beyond charts and code, Sauravsingh is a passionate mentor, guiding many towards financial and technological success. In his downtime, he's often found exploring new places or immersed in a compelling read.

Copyright @ Seben Capital

Crafted By Cre8r.in and Supported By $BACKRCOIN