Put-Call Parity & Option Pricing

Focus: OPTIONS

Alan Ellman Image Alan Ellman President, The Blue Collar Investor Corp.

This article has a few advanced concepts that I hope you find interesting but is not necessary to master or memorize, writes Alan Ellman of TheBlueCollarInvestor.com. Some of the material may make your head spin a bit as it did mine as I was writing the article!

Definition and Example
Put call parity is an option pricing concept that requires the time (extrinsic) values of call and put options to be in equilibrium so as to prevent arbitrage (Arbitrage is the simultaneous purchase and sale of an asset in order to profit from a difference in the price).

It is when the value of a call option, at one strike price, implies a certain fair value for the corresponding put, and vice versa. The argument, for this pricing relationship, relies on the arbitrage opportunity that results if there is difference between the value of calls and puts with the same strike price and expiration date. Arbitrageurs would step in to make profitable, risk-free trades until the departure from put-call parity is eliminated. This relationship is strictly for European-style options, but the concept also applies to American-style options, adjusting for dividends and interest rates. If the dividend increases, the puts expiring after the ex-dividend date will rise in value, while the calls will decrease by a similar amount. Changes in interest rates have the opposite effects. Rising interest rates increase call values and decrease put values.

chart
Put-call parity graph
Click to Enlarge

The above chart depicts a put-call parity relationship.