Investors will often hear the term put-call parity without fully comprehending its meaning or how it keeps options prices in line. Put-Call Parity states that for a given underlying price with the same strike prices and the same expiry for both puts and calls, the value of a call at a given price implies a value for the put, and the relationship of the two holds in the reverse. It is often stated that put-call parity only holds for European-style options as there is no early exercise. However, in practice, market makers on the Canadian Derivatives Exchange keep prices in line using the same parity principles for all American-style options. It is arbitrage* that maintains the parity between call, put, and the underlying stock.
One way to visualize this concept is to imagine a teeter-totter with call on one side, put on the other, and the base or fulcrum being the underlying security.
As the call goes up in value, the put goes down in value and vice versa.
The easiest way to understand this concept is to look at the choice between purchasing the stock outright or buying a call and selling a put in combination (combo). The long exposure to the market is the same for each choice. The basic formula states that the call – put = stock price – strike price + (Interest – Dividend).
When purchasing the stock alone we have to finance the position, pay interest, and the receipt of any dividends acts to reduce that borrowing cost. Should we instead choose to purchase the call and sell the put, then we do not receive any dividends and our financial costs are negligible.
Put-Call Parity allows for the creation of many synthetic positions.
We just examined the combo above which is also known as Synthetic Long Stock. Flipping the position around, selling the call and purchasing the put creates Synthetic Short Stock. The combination of the calls and puts at the same strike should always equal 100 deltas. 100 deltas will be equivalent to ±100 shares of the underlying.
A Canadian investor may also wish to create any of the following synthetic positions:
Just as we defined above, market makers use the three-sided relationship of stock, call, and put to maintain quotes and prices.
One method for maintaining this relationship and a favorite of market makers is the Conversion.
The Conversion is long stock combined with a long put and a short call. We observe immediately that the trade is both long and synthetically short 100 shares, with the same strike calls and puts equal to -100 shares, while simultaneously being long 100 physical shares. As identified above this position can also be viewed as:
We calculate the cost to carry the Conversion until expiration as Strike Price x Interest Rate x Time to Expiration – Dividend Received. Note the carrying cost is based on the strike price, not the stock purchase price!
Let’s look at the following example with At-The-Money strikes:
XYZ Stock is trading at C$50
Interest rate 3%
60 days until expiration
Dividend of 20 cents
50 strike put priced at $1.18
Cost to carry position until expiration $50.00 strike x .03 x 60/365 – $0.20 = $0.05
The market maker has calculated that these are the fair values of the calls and puts. Should the call be trading at $1.30, he would use the Conversion to buy the stock, buy the put, and sell the call. No matter what the underlying does, the market maker makes a profit at expiration of 7 cents for as many times as the arbitrage is available. Although the Conversion is often considered a riskless trade, there are potential risks involved should there be a change in dividend dates, the amount of the dividend, or in interest rates.
At expiration, a Conversion with European-style options will be closed at the strike price with either the 50 call or the 50 put being In-The-Money.
At expiration – XYZ above $50.00
At expiration – XYZ below $50.00
Final thoughts: Canadian investors can use these formulas in the option calculator to better understand the concepts of put-call parity to access how closely displayed prices are to the calculations.
Also, note that the Synthetic Short Put described above is the same as the widely used Covered Call!
*Arbitrage is the opportunity to profit from price differences in identical or similar instruments. It holds the prices of these various instruments in line.
In today’s electronic and highly efficient markets, arbitrage is primarily the role of market makers because they have the combination of speed and low cost to profit from small discrepancies in pricing.
Grigoletto Financial Consulting
Alan Grigoletto is CEO of Grigoletto Financial Consulting. He is a business development expert for elite individuals and financial groups. He has authored financial articles of interest for the Canadian exchanges, broker dealer and advisory communities as well as having written and published educational materials for audiences in U.S., Italy and Canada. In his prior role he served as Vice President of the Options Clearing Corporation and head of education for the Options Industry Council. Preceding OIC, Mr. Grigoletto served as the Senior Vice President of Business Development and Marketing for the Boston Options Exchange (BOX). Before his stint at BOX, Mr. Grigoletto was a founding partner at the investment advisory firm of Chicago Analytic Capital Management. He has more than 35 years of expertise in trading and investments as an options market maker, stock specialist, institutional trader, portfolio manager and educator. Mr. Grigoletto was formerly the portfolio manager for both the S&P 500 and MidCap 400 portfolios at Hull Transaction Services, a market-neutral arbitrage fund. He has considerable expertise in portfolio risk management as well as strong analytical skills in equity and equity-related (derivative) instruments. Mr. Grigoletto received his degree in Finance from the University of Miami and has served as Chairman of the STA Derivatives Committee. In addition, He is a steering committee member for the Futures Industry Association, a regular guest speaker at universities, the Securities Exchange Commission, CFTC, House Financial Services Committee and IRS.