What is: Put-Call Parity

What is Put-Call Parity?

Put-Call Parity is a concept in options trading that establishes a relationship between the prices of put options and call options with the same strike price and expiration date. This relationship ensures that there are no arbitrage opportunities in the options market.

Understanding Put-Call Parity

Put-Call Parity states that the price of a European call option minus the price of a European put option with the same strike price and expiration date should equal the current price of the underlying asset minus the present value of the strike price.

Implications of Put-Call Parity

Put-Call Parity is important because it helps traders and investors understand the relationship between options prices and the underlying asset. It also helps in pricing options accurately and identifying arbitrage opportunities in the market.

Put-Call Parity Formula

The Put-Call Parity formula is expressed as C – P = S – PV(K), where C is the price of the call option, P is the price of the put option, S is the current price of the underlying asset, and PV(K) is the present value of the strike price.

Arbitrage Opportunities

If Put-Call Parity is violated, it creates arbitrage opportunities for traders. Traders can exploit these opportunities by simultaneously buying and selling options to make a risk-free profit.

Factors Affecting Put-Call Parity

Several factors can affect Put-Call Parity, such as interest rates, dividends, and transaction costs. Traders need to consider these factors when trading options to ensure that Put-Call Parity holds true.

Put-Call Parity and Market Efficiency

Put-Call Parity is a key concept in the efficient market hypothesis, which states that asset prices reflect all available information. If Put-Call Parity is violated, it suggests that the market is not efficient.

Put-Call Parity in Practice

Traders and investors use Put-Call Parity to price options accurately and identify mispriced options in the market. By understanding Put-Call Parity, traders can make informed decisions when trading options.

Conclusion

Put-Call Parity is a fundamental concept in options trading that helps traders understand the relationship between options prices and the underlying asset. By applying Put-Call Parity, traders can price options accurately and identify arbitrage opportunities in the market.