Parity in options

Similar to how synthetic oil is not extracted from the fossil fuels beneath the ground.

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  • Put-call parity states that simultaneously holding a short European put and long European call of the same class will deliver the same return as holding one forward contract on the same underlying asset, with the same expiration, and a forward price equal to the option's strike price.
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Rather synthetic oil is manufactured with chemicals and is man-made. Similarly, synthetic positions in stocks and options are generated from positions in other instruments. The call and put would have the same strike price and the same expiration.

By taking these two combined positions long call and short putwe can replicate a third one long stock. Remember the put premiums typically increase when the stock prices decline parity in options negatively impacts the put writer; and of course the call premiums typically increase as the stock price increases, positively impacting the call holder. Therefore, as the stock rises, the synthetic position also increases in value; as the stock price falls, the synthetic position also falls.

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An investor can purchase the call and write the put. In the previous example, if the relationship did not hold, rational investors would buy and sell the stock, calls and puts, driving the prices of the calls, puts and stock up or down until the relationship came back in line.

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Eventually the buying of the calls would drive the price up and the selling of the puts would cause the put premiums to decline and any selling of the stock would cause the stock price to decline also. Other factors too will change the relationship — notably dividends and interest rates.

The previous examples show how the markets participants would react to a potential arbitrage opportunity and what the impact may be on prices.

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The strike price of the call and put are the same. This assumes the strike prices and the expirations are the same on the call and put with interest rates and dividends equal to zero.

Interest is a cost to an investor who borrows funds to purchase stock and a benefit to investors who receive and invests funds from shorting stock typically only large institutions receive interest on short credit balances.

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Higher interest rates thus tend to increase call option premiums and decrease put option premiums. Long stock requires capital.

  1. In the case of dividends, the modified formula can be derived in similar manner to above, but with the modification that one portfolio consists of going long a call, going short a put, and D T bonds that each pay 1 dollar at maturity T the bonds will be worth D t at time t ; the other portfolio is the same as before - long one share of stock, short K bonds that each pay 1 dollar at T.
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  3. The parity price concept is used for both securities and commodities, and the term refers to when two assets are equal in value.

The cost of these funds suggests the call seller must ask for higher premiums when selling calls to offset the cost of interest on money borrowed to purchase the stock. Conversely, the offset to a short put is short stock.

Individuals trading options should familiarize themselves with a common options principle, known as put-call parity. Put-call parity defines the relationship between calls, puts and the underlying futures contract. This principle requires that the puts and calls are the same strike, same expiration and have the same underlying futures contract. The put call relationship is highly correlated, so if put call parity is violated, an arbitrage opportunity exists.

As a short stock position earns interest for some large investors at leastthe put seller can ask for a lower premium as the interest earned decreases the cost of funds. This reduces the cost of carry — as the cost of carrying the stock position into the future is reduced from the dividend received by holding the stock. Opposite of interest rates, higher dividends tend to reduce call option prices and increase put option prices.

Parity Price

Professional traders understand the relationships among calls, puts, interest rates and dividends, among other factors. For individual investors, understanding the early exercise feature of American style options is essential.

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When writing options, intuition as to when assignment may occur and when holding options understanding when to exercise at an opportunistic time is very important.

For dividend paying stocks, exercise and assignment activity occurs more frequently just before call exercises and after put exercises an ex-dividend date. Our position simulator and pricing calculators can help evaluate these relationships: Visit our learning resources by topic pages for additional insight into parity in options pricing.