CandleFocus

Put-Call Parity

Candlefocus Editor
Put-call parity is an important concept in the financial markets that shows the mathematical relationship between the prices of a European put option and a European call option under certain conditions. Put options give the car holder the right but not the obligation to sell the underlying asset at a specified price at the date of expiration. On the other hand, a call option gives the car holder the right but not obligation to buy the underlying asset at a certain price at the date of expiration.

Put-call parity shows that when two options have the same underlying asset, the same expiration date, and the same strike prices, then the price of the call option must equal the price of the put option plus the initial stock price minus the present value of the strike price. This equation can be described as:

C + PV(x) = P + S

where C is the price of a call option, PV(x) is the present value of the strike price, P is the price of a put option and S is the initial stock price. Put-call parity allows investors to determine whether one option is underpriced or overpriced compared to the other.

It is important to note that put-call parity only applies to European options, while American options can be exercised before the expiration date, which precludes put-call parity to be applicable. If a violation of the put-call parity occurs, arbitrage opportunities arise and investors can take advantage of the mispricing to make a profit.

In summary, put-call parity is an essential concept underlying the pricing of options as it introduces a mathematical relationship between two different options that have the same underlying asset, strike price and expiration. The rationale behind the put-call parity is that the price of a call option should imply a certain fair price for the corresponding put option and vice versa. If the parity is violated, then traders can spot arbitrage opportunities in the market.

Glossary Index