Put–call parity is a relationship between the price of a European call option and European put option with the same strike price and time to expiration. It is one of the most important relationships in option pricing. It provides a tool for constructing equivalent positions. This post is a general discussion of put-call parity. In the next post, we discuss put-call parity in greater details for various underlying assets – e.g. stocks, treasuries and currencies.
Synthetic forward – buying a call and selling a put
Suppose you follow the strategy of buying a call and selling a put (at time 0) where both options have the same underlying asset, the same strike price and the same time to expiration. At time , it is certain that you will buy the underlying asset by paying the strike price . Too see this, if at expiration of the options, the asset price is more than , then you, as a call buyer will want to exercise the call option and pay to buy the asset. If the asset price at expiration is less than , then you as a call buyer will not want to exercise but the put buyer that bought from you will want to exercise the put option. As a result, you will also buy the asset by paying the strike price . Thus by entering into a long call and a short put (on the same underlying asset, with the same strike and same time to expiration), you will end up buying the underlying asset at time at the strike price . What is being described sounds very much like a forward contract – a contract in which you can lock in a price today to pay for an asset a time in the future. For this reason, the strategy of buying a call and selling a put is called a synthetic forward contract.
The above discussion on synthetic forward suggests that there are two ways to buy an underlying asset (e.g. a stock) at time in the future. They are:
- Enter into a forward contract to buy the underlying asset by paying the forward price at time .
- Buy a call and sell a put today (on the same underlying asset, with the same strike price and the same time to expiration).
The two different strategies generate the same payoff. Hence they must have the same cost. Otherwise there would be arbitrage opportunities. By the “no-arbitrage pricing” principle, the net cost of the two strategies must equal. The cost at time 0 of the “buy call sell put” strategy is , plus the present value of the strike price , where and represent the call option premium and put option premium, respectively. The cost at time of the forward contract strategy is the forward price . Thus cost at time 0 of the forward contract strategy is the present value of . We can now equate the costs of the two strategies.
The notation denotes the time 0 value of an amount at the time . Equation (0) is one form of the put-call parity, which is a statement that buying a call and selling a put is equivalent to a synthetic forward contract. It also tells us that buying a call and selling a put plus lending the present value of the strike price is equivalent to buying the underlying asset.
Other versions can be derived by algebraically rearranging equation (0), some of which have interesting interpretations. The following is one of them.
The left hand side of (1) is the net option premium – the premium paid for the call less the premium received for the put. When this amount is not zero, it is in effect the premium of the synthetic forward contract (this amount is the initial cash outlay for the synthetic forward contract). This is one difference between a synthetic forward and an actual forward. Note that an actual forward contract has zero premium (the initial cash outlay is zero). Another difference is that the “forward price” of the synthetic forward is the strike price of the options and while the forward price of the actual forward is .
Suppose that the strike price is chosen to be less than the actual forward price . Then the holder of the synthetic forward contract can buy the asset at a price lower than the forward price. This is certainly a benefit. In order to get this benefit, the holder of the synthetic forward contract has to pay the net option premium, which is the result of the call being more expensive than the put. In this scenario, the net payment is a little higher at time 0. As a result, the payment at time is a little less.
Suppose that the strike price is chosen to be more than the actual forward price . Then the holder of the synthetic forward position is obliged to pay for the underlying asset at a price higher than the forward. It then makes sense for the holder of the synthetic forward position to be compensated by receiving a payment initially. This would occur if the put is more expensive than the call. In this scenario, the net payment is a little less at time 0, leading to a larger payment at time .
If the strike price is chosen to be the same as the forward price , then equation (1) suggests that the synthetic forward mimic exactly the actual forward (both have zero premium). For this to happen, premiums for the put and the call must be equal.
The right hand side of (1) is the value of the discount resulted from paying the strike price instead of the forward price. This version of the put-call parity says that the discount is identical to the net option premium.
Protective put and covered call
The next two versions can be interpreted in terms of a protective put and a covered call. A protective put consists of a long asset position and a long put. It is the strategy of buying a put option to protect against the risk of falling prices of a long asset position. A covered call consists of a long asset position and a short call. The covered call uses the upside profit potential of the long asset to back up (or cover) the call option sold to the call buyer. First, the protective call version:
The left hand side of (2) is the time 0 cash outlay of buying the underlying asset and buying a put. The right hand side of (2) is time 0 cash outlay of buying a call option (with the same strike and time to expiration as the put) and buying a zero-coupon bond costing . Thus equation (2) tells us that buying the underlying asset and buying a put on that asset (i.e. a protective put) have the same cost and generate the same payoff as the buying a call option and buying a zero-coupon bond. Adding a bond lifts the payoff graph but does not change the profit graph. Thus buying the asset and buying a put has the same profit as buying a call. Because of Equation (2), buying the underlying asset and buying a put is called a synthetic long call option. This point is also discussed in this previous post. Here’s the version of the put-call parity involving covered call.
The left hand side of (3) is the time 0 cash outlay of buying the underlying asset and selling a call on that asset (i.e. a covered call). The right hand side of (3) is the time 0 cash outlay of buying a zero-coupon bond costing and selling a put. Thus a covered call has the same cost and same payoff as buying a bond and selling a put. Once again, adding a bond does not change the profit. Thus a covered call has the same profit as selling a put. For this reason, a buying the underlying asset and selling a call is called a synthetic short put option. This point is also discussed in this previous post.
As a summary, we gather the various versions of the put-call parity in one place along with their interpretations.
Versions of Put-Call Parity
Interpretation: Time 0 cost of a long asset = Time 0 cost of (Long Call + Short Put + Long Bond).
Interpretation: Net option premium (call option premium that is paid out less put option premium received) = the value of the discount as a result of paying the strike price instead of the forward price.
Interpretation: Time 0 cost of (Long Asset + Long Put) = Time 0 cost of (Long Call + Long Bond).
The portfolio on the left (Long Asset + Long Put) is called a protective put.
Because of (2), a protective put is considered a synthetic long call option.
Interpretation: Time 0 cost of (Long Asset + Short Call) = Time 0 cost of (Long Bond + Short Put).
The portfolio on the left (Long Asset + Short Call) is called a covered call.
Because of (3), a covered call is considered a synthetic short put option.
In each of the above versions of parity, the portfolio of investments on the left side is equivalent to the portfolio of investment on the right side. More specifically, each version equates the costs of obtaining the portfolios at time 0. The bond indicated in the interpretations is a zero-coupon bond. A long position on a bond means lending.
One comment about the four parity relations discussed here. We derive the first one, which is version (0) by comparing the cash flows of two equivalent investments. The other three versions are then derived by algebraically rearranging the first version. As a learning device, it is a good idea to think through the cash flows and payoff of versions (2) through (3) independently of version (0). Doing so is a great practice and will help solidify the understanding of put-call parity. Drawing payoff diagrams can make the comparison easier. It is also possible to just think through the cash flows of both sides of the equation. For example,
let’s look at version (2). On the right side, you lend and buy a call at time 0. Then at time , you get back. If the price of the underlying asset at that time is more than , then you exercise the call – using the that you receive to buy the asset. So on the right hand, side, the payoff is if asset price is more than and the payoff is if asset price is less than (you would not exercise the call in this case). On the left hand side, you lend and buy a put at time 0. At time , you get back and you use it to pay for the asset. So you own the asset at time . If the asset price at time is less than , you exercise by selling the asset you own and receive . Thus the payoff on the left hand side is if asset price is more than (in this case you don’t exercise the put and instead you profit from holding the asset). The payoff is if the asset price at time is less than (this is the case where you exercise the put option). The comparison shows that both sides of (2) have the same payoff at time . Then it must be the case that they also have the same cost at time 0. Otherwise, there would be an arbitrage opportunity by buying the side that is low and sell the other side.
The basic put-call parity relations discussed in this post can be used in a “cookbook” fashion to create synthetic assets. For example, version (0) indicates that buying a call, selling a put and lending the present value of the strike price has the same cost and payoff as buying a non-dividend paying stock. Thus version (0) is a basis for constructing a synthetic stock. In the next post, we discuss the put-call parity for different underlying assets.