Introduction to Put Call Parity
Put Call Parity is a fundamental concept of options trading; it is a simple idea that aids you in determining the price of an option contract and helps value a call or a put basis other known components.
Put Call Parity has been defined in different terms; textbooks defines put-call parity as partial variance of an option price regarding the stock price. However, in laymen’s terms, put-call parity is best understood as the state where a long call and a short put equal the value of the stock at the same strike price. Also, movement of any of the components impacts all other pieces in the chain. At this-this state, you are aware of what put option will be when you choose a certain call or put option.
Three factors are essential in put-call parity: call options, put options along with underlying. The Put Call Parity theory states that, when either of the three components are chosen, they should be equivalent to the third component (subject to the specifics of the put call parity formula). When one or two of the components are unequal to the third, it gives an indication of mispricing along with the presence of arbitrage opportunities. Therefore, Put Call Parity illustrates the presence of overall balance in your portfolio prices. In respect to this theory, the violation in the pricing model leads to the inherent defectiveness of put-call parity.
The Put-call parity rule applies to European options only, that is options where exercise is only permitted at the expiration date of the option. This is an indication that it is not appropriate for American options which are applicable all time before expiring date.
Importance of Put Call Parity to an investor
The PCP theorem is efficient and easy for you to determine the fair value of an option and situation where it is applicable. There are various composite models which perform independent pricing of options such as Black-Scholes and Binomial models, but if used under the presence of few conditions, such as PCP, simpler models can be employed with tremendous results.
Put Call Parity is quite beneficial to individual investors as it enables them to trade without making unnecessary risks on their portfolio, denoted as a riskless borrowing portfolio; the ability to buy both calls alongside put options allow for the possibility for the portfolio to be risk-free. An increase in underlying stock facilitates to rise in the value of the stock position; you can owe only the call option position only and allow the put option to invalidate and vice versa when your stock falls. Under this theory, you can make your decisions in trade without experiencing marketing risks.
Importance of put-call parity to the trader
If you come across a situation where put-call parity is invalid, you have an arbitrage opportunity. Arbitrage is the situation where you purchase and simultaneously sell the same (or equivalent) asset with the aim to make more profit from the price variance; taking advantage of mispricing between the two assets. With advancements in technology, performing these calculations across a wide range of instruments real time greatly aids in the identification of mispricing opportunities. This sort of arbitrage is known as synthetic position.
Put-call parity is beneficial as a quick guide to value option contracts as long as the option you are evaluating is compared against its’ corresponding call or put and underlying instrument.