Put Call Parity

Put-call parity is an important concept in investing. Indian capital markets can be highly rewarding for investors if the capital allocation is effective. Experienced investors ensure that they allocate their capital, keeping diversification in mind across various asset classes and included investment instruments.

• Put-call parity defines the relationship between call and put options with the same expiration date, strike price, and underlying asset.
• Violations of put-call parity present low-risk profit opportunities through arbitrage.
• This principle ensures options are priced fairly in the market, promoting overall reliability.

The financial market in India is a lucrative avenue for investors to grow their wealth. One of the most popular investment contracts is the options contract. These provide a flexible method of investment and profit generation. As an investor, you must also know about the concept of put call parity.

In this article, we will discuss what put call parity is, its applicability, explain the concept with an example, illustrate its importance and relationship with arbitrage, and more. Keep reading to know how put and call parity directly influences options trading strategies.

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If you are curious about derivatives trading, understanding the put call parity will be significant for you. The concept governs the relationship of two European call and put options from an asset class. It is important for the two options to have the same strike price, expiration date, and underlying asset. This principle states the value of call and put options and clearly defines their consistency.

In simple terms, the put call parity shows how the prices of put and call options are related. For instance, assume that you have two options contracts–a long call option and a short put option. Both these have the same expiration date and strike price. According to this principle, the cost of holding these two options should match the returns from one share of the underlying stock. This essentially makes sure that options are priced fairly in the market.

The put call parity applies only to European options. This means that both options would belong to the same asset class. In addition, put call parity is only applicable when the two options have the same underlying asset, strike price, and expiration date.

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A key point to remember is that the principle of put call parity only applies to European options. In addition, the two given options need to have the same underlying asset, expiration date, and strike price.

The underlying asset for both the options contracts has to be the same. It could be a commodity, stock, currency, etc.

When the put call parity is not followed and the principle is violated, the situation presents opportunities for arbitrage. This is a trading and investment opportunity where the difference in prices of an asset among various markets is leveraged by some seasoned traders.

When the parity is broken, either the call or the put option becomes costlier compared to the other.

Let us understand the concept of the put call parity with the help of an example.

Suppose you have identified two options contracts, with the details mentioned below:

• Call option
  • Strike price - Rs. 75.00
  • Premium - Rs. 2.00
  • Expiration - 3 months
• Put option
  • Strike price - Rs. 75.00
  • Premium - Rs. 3.00
  • Expiration - 3 months

With a spot price of Rs. 74 and an annual risk-free interest rate of 6%, the put-call parity can be measured as:

• Call option- C + PV(K) = P + S / (1 + r)^T
• Call price- C + 73.35 = 3.00 + 73.50 / (1 + 0.06/4)^(3/12)
• Put option- P + S / (1 + r)^T = C + PV(K)
• Put price- P + 73.35 = 2.00 + PV(75.00)

According to the calculations, the call option price should be Rs. 0.85 and the put option price should be Rs. 1.65. If the actual prices in the market are different from these calculations, it signals a potential arbitrage opportunity.

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The fundamental principle of put call parity is vital for all investors in the derivatives market who want to maximise earning opportunities. The concept is primarily used to monitor and seek opportunities for arbitrage trades that help make profits at a low risk.

You can think of the put call parity concept as a way to verify the consistency of options prices in relation to the value of the underlying asset. These measurements can be utilised to craft options trading strategies that enable hedging leveraging the put and call options and the underlying asset.

The formula for put call parity is:

Call option price + Present strike price value = Put option price + Present market price of underlying asset

Also read: Accrued interest

The equation that represents the put call parity can be expressed as the price of the call option plus the current value of the strike price equals the cost of the put option plus the current market price of the underlying asset. This can be represented as follows:

Call option price- Put option price = Current value of underlying asset - Current value of strike price

Put call parity is a crucial concept for investors in the Indian financial market, ensuring the fair pricing of options and creating opportunities for arbitrage. Understanding this principle helps investors craft effective trading strategies and maximise profit potential with minimal risk.