Any trader in options markets must be familiar with the concept of put-call paraity. What is put-call paraity? Let's start with the basics.
Optional securities fall under the umbrella of derivative securities. Option's value is fundamentally tied to the worth of another object, which is why they are called derivative securities. An option contract gives you the ability to purchase or sell the asset at a specified price. You can exercise this right at any time, with no obligations.
Because options are tied to so many other factors, they can be very colorful. Multiple opportunities can increase or decrease the value of an option over its lifetime. Options trading can be compared to chess. There are many pieces that move constantly. As implied volatility increases, option prices will move up or down. Options premiums also depend on the demand and supply of the options.
The call option gives the right to its holder the ability to buy stock. The put option holder has the right to dispose of a share. A call option can be thought of as a down payment that you will receive in the future.
There are two styles available: American and European. The American style option can be used at any time during its life. The European option, on the other hand can only be used after the expiration date. The put-call parity is only applicable to European-style options.
The market for options is witnessing the rise of the put-call parity. It is a stunning reality. Understanding its mechanisms will help you to understand strategies. To determine the options value of an option, professionals use many factors.
Put-call parity helps you to understand how supply and demand affect the price of options. It also shows you how the value of all expirations and strikes are interlinked when they relate to the same underlying security.
Functional equivalence, also known as being equal or having equal value, is the term used to describe "parity". Options theory is organized in a way that puts and calls complement one another in terms of their value and price.
If you know the value of a call option you can quickly calculate the value of a complimentary put option with a matching strike price and expiration date. Investors and traders need this knowledge for many reasons. It can help you identify profitable opportunities even if the option premiums do not function. It is important to have a good understanding of put-call Parity. This can help you determine the relative value of an option when you consider adding it to your portfolio.
Put-call parity is the relationship between the price of a European option and a European option. These two options must have the same underlying asset; they must have the same strike price, the same expiration date.
Let's say a trader has both a European short put and European long call. Put-call parity states that this is equivalent to one forward contract for the same asset with the same expiration date and one forward price equal to the strike price.
Arbitrage is possible if the price of the put differs from the call price and the relationship between them does not hold. The result is that skilled traders can theoretically still make a profit and not take any risk. These kinds of trades are rare in liquid markets and only happen within a narrow window.
This equation is used to calculate put-call parity.
C + PV(x), = P + S
Here are some examples
The put-call parity applies only to European options that can be used on the expiration date. This is in contrast to American options, which allow the trader to exercise the options before.
Let's look at an example to show how it works. Let's say you bought a European call option to purchase TK stock. The expiration date is one year after the date of purchase and the strike price for TK stock is Rs 150. To purchase the call option, you will need to pay Rs 50 You know that you can buy this call option to purchase TK stocks at Rs 150 on the expiration date, regardless of the current market price. You see that TK stocks are trading at Rs 100 after a year. So you decide not to use your option. You will use your option to buy shares at Rs 150 if TK shares are traded at Rs 200 each. You will break even as you only spent Rs 50 to purchase the option. If TK stocks rise above Rs 200, this amount will be your profit.
Let's say you also want to sell a put option on the stock. All options have the same expiration date, strike price, and price. The option is sold for Rs 50. You do not have the right of use the option as you no longer own it. You have also bought the right to purchase the stock at the strike price from the person who purchased it. The buyer is free to sell the stock, but there are no obligations. Regardless of how much TK shares are selling for, you must accept the deal.
The buyer will buy the TK stocks at Rs 150 if they are priced at Rs 100 a year later. You will both make a profit in this scenario since the seller of the option earned Rs 50 and the buyer spent Rs 50 to buy it. If the stock of the company is worth more than Rs 150 then your profit will be Rs 50. The buyer will not use the option that he purchased. You will lose money if the share price falls below Rs 100
Some interesting facts will be revealed if you create a graph and plot the profit or loss on each position for different stock prices of TK. Let's say that the profit or loss on the long call is multiplied by the profit or loss on the short put. If we take a forward contract at Rs 150 from TK, we will see a profit or loss equal to the amount that we would have made if we had taken a one-year-old contract. You will lose if the shares are traded at prices below Rs 150. You will make a profit if they are priced higher. We have left out transaction fees to make it easier for you to understand.
You can better understand the put-call parity by comparing the performance of a fiduciary and protective call belonging to the same class. When we combine a long position in stock and a long put, we get a protective put. The stock's negative impact is minimized by this combination. Fiduciary calls combine a long call with cash equal to the strike price's current value. This ensures that the investor has enough money to use the option at its expiration date.
Put-call parity means that calls and puts must belong to the same strike, have a similar expiration date, and be part of the same futures contract. Parity is a highly correlated relationship, so arbitrage is possible if it is broken.
The European put-call parity controls the prices of call options and puts. If the market were perfectly efficient, then the prices for the put and call option would be managed in this way.
C + PV(x), = P + S
Arbitrage opportunities are available in situations where one side is heavier than the others. If a trader sells one side of an equation and buys the other, he or she can make a hassle-free profit. This means that a trader can sell a put or short the stock, and then buy the risk-free asset/call. However, arbitrage is rarely used in real life. You might also find that the margins available by arbitrage are often so small that you need to invest large sums of capital in order to reap the benefits.
Options can be a useful tool for traders. Understanding options, put-call paraity and arbitrage is key to your market knowledge. This will open up new opportunities for profitability and help you to manage risk better.
Put-call parity can be applied to options markets, but it is not limited to commodities. It can be used in all asset markets that have a dominant market for option. Understanding put-call parity is a good idea. This will give you a greater understanding of markets and will allow you to outperform your competition. The key to success in this trade is being able to spot market divergence early. Your chances of success are higher if you have a deep understanding.