What Is Put Call Parity And How Can It Help You?

Put call parity is an important concept in the world of options trading. It’s a mathematically simple concept that helps us to determine the value of options relative to other factors in the equation and make sound trading decisions.

Put Call Parity Defined

The textbook definition of put call parity is that it’s a partial differential of option price with respect to stock price. In laymen’s terms, this means that you have a situation where put and call price are tied together. When one moves, the other one moves as well. In other words, if call option X is this, put option Y should be this.

The formula for Put Call Parity states that:

Call Price – Put Price = Stock Price – Strike Price

There are four factors that play a part in put call parity – put options, call options, the strike price and the underlying. The theory states that any 3 of these 4 should equal the fourth one. No two of these instruments should be unequal to the third or else there’s a mispricing and an arbitrage opportunity. Thus, put call parity shows that there’s overall balance in the prices. According to this idea, any pricing model whose prices violate put call parity must be inherently flawed.

Put call parity can only be applied to European options and other options where the expiry date is set and the options can’t be exercised before that day. This means that it can’t be used for American options, which can be exercised at any time prior to expiration.

What It Means To You As An Investor

Why should you care about put call parity? For one thing, it is both simple and effective in determining the value of an option and what you should do with it. There are more complex models such as Black Scholes and the binomial model, but as long as a few conditions are met, this much simpler model can be used with great results.

Put call parity is very advantageous to you because it allows you to trade without making great risks. It’s often explained as a ‘riskless borrowing portfolio.’ It’s considered risk-free because you can use it to buy both call and put options. If the underlying’s stock rises, the stock position increases in value. You then owe on the call option position only and let the put expire. It’s the opposite if the stock falls. In this way, you can make your decision without dealing with the risks of the market.

How Put Call Parity Helps You As A Trader

If you find an option that violates put call parity, you have an arbitrage opportunity. Arbitrage is the buying and selling simultaneously of the same (or equivalent) asset in order to profit from the price difference. You’re basically taking advantage of mispricing in the market. This is much harder to do these days with all of the technology used to continually analyze the market; but, if inefficient pricing setups can be found, it’s an instant and risk-free way to make a profit. This type of arbitrage opportunity is called a synthetic position.

Like anything else in trading, put call parity isn’t a golden rule that lets you make risk-free investments. However, if you understand it well, you can use it to guide you in deciding when it’s time to change your investment strategy.