## Put-Call Parity, Part 2

Put-call parity is a key idea in option pricing theory. It provides a tool for constructing equivalent positions. The previous post gives a general discussion of the put-call parity. In this post, we discuss the put-call parity for various underlying assets, i.e. the parity relations in this post are asset specific. The following is one form of the general put-call parity. This is the version (0) discussed in the previous post.

$\text{ }$
Put-Call Parity
$\displaystyle PV(F_{0,T})=C(K,T)-P(K,T)+PV(K) \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ (0)$
$\text{ }$

The put-call parity has four components – the price of the call, the price of the put, the present value of the strike price and the present value of the forward price. In the general form of the put-call parity, the present value of the forward price completely take the dividends and time value of money into account. For a specific type of underlying asset, in order to make the put-call parity more informative, we may have to take all the interim payments such as dividends into account. Thus in the parity relations that follow, the general forward price is replaced with the specific forward price for that asset. Synthetic assets can then be created from the asset-specific put-call parity that is obtained.

The notations used here are the same as in the previous posts. The notation $F_{0,T}$ is the forward price. All contracts – forward and options and other type of contracts – are set at time 0 (today) and are to end at time $T$. The strike price for the options is $K$. The letter $r$ denotes the risk-free annual continuous interest rate. If the strike price $K$ is paid for an asset at time $T$, its present value at time 0 is $PV(K)=e^{-r T} K$. All options discussed here are European options, i.e. they can be exercised only at expiration.

All the parity relations that follow will obviously involve a call and a put. To make this extra clear, the call and the put in these relations have the same strike price and the same time to expiration. Thus whenever we say buying a call and selling a put, we mean that they are compatible in this sense.

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Put-call parity for stocks

Forward prices for stocks are discussed here. For a non-dividend paying stock, the forward price is $F_{0,T}=S_0 e^{r T}$, i.e. the price to pay for the stock in the future is the future value of the time 0 stock price. The following is the put-call parity of a non-dividend paying stock.

$\text{ }$
Put-Call Parity – non-dividend paying stock
$\displaystyle S_0=C(K,T)-P(K,T)+e^{-r T} K \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ (S1)$
$\text{ }$

The parity (S1) says that there are two ways to buy a non-dividend paying stock at time 0. One is the outright stock purchase (the left side). The other way (the right hand side) is to buy a call, sell a put and lend the present value of the strike price $K$. By buying a call and selling a put, it is certain that you will buy the stock by paying $K$, which is financed by the lending of $PV(K)=e^{-r T} K$ at time 0. In both ways, you own the stock at time $T$. There is a crucial difference. In the outright stock purchase, you own the stock at time 0. In the “options” way, the stock ownership is deferred until time $T$. For the non-dividend paying stock, an investor is probably indifferent to the deferred ownership in the right hand side of (S1). For dividend paying stock, deferred ownership should be accounted for the parity equation.

$\text{ }$
Put-Call Parity – dividend paying stock (discrete dividend)
$\displaystyle S_0-PV(\text{Div})=C(K,T)-P(K,T)+e^{-r T} K \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ (S2)$
$\text{ }$

In (S2), $\text{Div}$ refers to the dividends paid during the period from time 0 to time $T$ and $PV(\text{Div})$ refers to the time 0 value of $\text{Div}$. The deferred stock ownership on the right hand side of (S2) does not have the dividend payments while the outright stock ownership has the benefit of the interim dividend payments. Thus the cost of deferred stock ownership must be reduced by the amount of the dividend payments. This is why the dividend payments are subtracted on the left hand side. The next parity relation is for a stock or stock index paying continuous dividend.

$\text{ }$
Put-Call Parity – dividend paying stock (continuous dividend)
$\displaystyle S_0 e^{-\delta T}=C(K,T)-P(K,T)+e^{-r T} K \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ (S3)$
$\text{ }$

Continuous dividends are reinvested (as additional shares) where $\delta$ is the annual continuous compounded dividend rate. The forward price is $F_{0,T}=S_0 e^{(r-\delta) T}$. The present value of the forward price is $S_0 e^{-\delta T}$, which is the left hand side of (S3). The left side of (S3) is saying that $e^{-\delta T}$ shares at time 0 will accumulate to 1 share at time $T$. The right hand side is saying that buying a call, selling a put and lending out the present value of $K$ at time 0 will lead to ownership of 1 share at time $T$.

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Synthetic stocks and other synthetic assets

In this section, we consider synthetic assets that can be created from the parity relations on stocks. These synthetic assets are parity relations. The left side of each of these relations is an asset that exists naturally in the financial market place. The right hand side is the synthetic asset – a portfolio that is an alternative asset that has the same cost and payoff, thus a portfolio that mimics the natural asset. For example, a synthetic stock is a combination of put and call and a certain amount of lending that will replicate the same payoff as owning a share of stock. In the next section, we will resume the discussion of put-call parity on underlying assets.

Each of the parity relation in this section is derived from an appropriate stock put-call parity by solving for the desired asset. For a synthetic stock, we put the stock on the left hand side by itself.

$\text{ }$
Synthetic stock – non-dividend paying
$\displaystyle S_0=C(K,T)-P(K,T)+e^{-r T} K \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ (Syn1)$
$\text{ }$
Synthetic stock – discrete dividend paying
$\displaystyle S_0=C(K,T)-P(K,T)+e^{-r T} K+PV(\text{Div}) \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ (Syn2)$
$\text{ }$
Synthetic stock – continuous dividend paying
$\displaystyle S_0 =(C(K,T)-P(K,T)+e^{-r T} K) \ e^{\delta T} \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ (Syn3)$
$\text{ }$

Note that (Syn1) is identical to (S1) since there is no dividend. The portfolio on the right hand side is the synthetic stock. For example, for (Syn2), the strategy of buying a call, selling a put, and lending out the present values of the strike price and the interim dividends is an alternative way to own a discrete dividend paying stock. There is a crucial difference between outright stock ownership on the left hand side and the deferred stock ownership on the right hand side. The synthetic stock pays no dividends. Thus the outright stock ownership is worth more than the synthetic stock. In other words, the cost of outright stock ownership exceeds the synthetic cost. By how much? By the present value of the interim dividends. This is why the present value of the dividend payments is added to the right hand side of (Syn2) and (Syn3).

Now we consider synthetic T-bills (or synthetic risk-free asset).

$\text{ }$
Synthetic T-bill – based on non-dividend paying stock
$\displaystyle e^{-r T} K=S_0-C(K,T)+P(K,T) \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ (T1)$
$\text{ }$
Synthetic T-bill – based on discrete dividend paying stock
$\displaystyle e^{-r T} K+PV(\text{Div})=S_0-C(K,T)+P(K,T) \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ (T2)$
$\text{ }$
Synthetic T-bill – based on continuous dividend paying stock
$\displaystyle e^{-r T} K=S_0 e^{-\delta T}-C(K,T)+P(K,T) \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ (T3)$
$\text{ }$

In (T1), (T2) and (T3), the right hand side is the synthetic way of creating a T-bill. Let’s look at (T3).

Relation (T3). In order to hold a synthetic T-bill, you buy $e^{-\delta T}$ shares of stock, sell a call and buy a put at time 0. At time $T$, the $e^{-\delta T}$ shares become 1 share, which will be used to meet the demand of either the call option or put option. If the stock price is more than $K$, the call buyer will want to exercise the call and you as a seller of the call will have to sell 1 share at the strike price $K$. If the stock price is less than $K$ at time $T$, you as the put buyer will want to sell 1 share of stock at the strike price $K$. So in either case, you have the amount $K$ at time $T$, precisely the outcome if you buy a T-bill with maturity value $K$.

Next we consider synthetic call options.

$\text{ }$
Synthetic call – based on non-dividend paying stock
$\displaystyle C(K,T)=S_0-e^{-r T} K+P(K,T) \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ (C1)$
$\text{ }$
Synthetic call – based on discrete dividend paying stock
$\displaystyle C(K,T)=S_0-e^{-r T} K-PV(\text{Div})+P(K,T) \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ (C2)$
$\text{ }$
Synthetic call – based on continuous dividend paying stock
$\displaystyle C(K,T)=S_0 e^{-\delta T}-e^{-r T} K+P(K,T) \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ (C3)$
$\text{ }$

The right hand side of the above three equations are synthetic ways to buy a stock call option. They can be derived by solving for $C(K,T)$ in the put-call parity relation in respective stock. It also pays to think through the cash flows on both sides. The right hand side of each of (C1) through (C3) consists of a leveraged position (stock purchase plus borrowing) and a long put to insure the leveraged position. For example, in the right hand side of (C1), borrow $e^{-r T} K$ and buy one share of stock (the leveraged position). Then use a purchased put to insure this leveraged position.

Another way to look at synthetic call is that the right hand side consists of a protective put and borrowing. A protective put is the combination of a long asset and a long put. For example, the right hand side of (C1) consists of $S_0+P(K,T)$ (a protective put) and the borrowing of $e^{-r T} K$, the present value of $K$.

Here’s the synthetic put options.

$\text{ }$
Synthetic put – based on non-dividend paying stock
$\displaystyle P(K,T)=C(K,T)-S_0+e^{-r T} K \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ (P1)$
$\text{ }$
Synthetic put – based on discrete dividend paying stock
$\displaystyle P(K,T)=C(K,T)-S_0+e^{-r T} K+PV(\text{Div}) \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ (P2)$
$\text{ }$
Synthetic put – based on continuous dividend paying stock
$\displaystyle P(K,T)=C(K,T)-S_0 e^{-\delta T}+e^{-r T} K \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ (P3)$
$\text{ }$

The right hand side of each of (P1) through (P3) is a synthetic put, a portfolio that mimics the payoff of a put option. Note that the right hand side consists of a long call and a short stock position (this is a protective call) and the lending of the present value of $K$.

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Put-call parity for currencies

A previous post on forward prices shows that the currency forward price is $F_{0,T}=x_0 \ e^{(r-r_f) T}$ where $x_0$ is the exchange rate (units of domestic currency per unit of foreign currency, e.g. dollars per euro), $r$ is the domestic risk-free rate and $r_f$ is the foreign currency risk-free rate. The present value of $F_{0,T}$ is then $e^{-r T} \ F_{0,T}=x_0 \ e^{-r_f T}$, which is the number of units of the domestic currency (e.g. dollars) at time 0 in order to have one unit of foreign currency (e.g. euro) at time $T$. Substituting $e^{-r T} \ F_{0,T}=x_0 \ e^{-r_f T}$ into the parity relation of (0), we have:

$\text{ }$
Put-Call Parity – Currencies
$\displaystyle x_0 \ e^{-r_f T}=C(K,T)-P(K,T)+e^{-r T} K \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ (F1)$
$\text{ }$
$\displaystyle x_0 \ e^{-r_f T}-e^{-r T} K=C(K,T)-P(K,T) \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ (F2)$
$\text{ }$

In (F1) and (F2), we assume that the call and the put are denominated in dollars, i.e. both the strike price $K$ and the put premium and call premium are denominated in dollars. For ease of discussion, let’s say the foreign currency is euro. The premium $C(K,T)$ discussed here is in dollars and grants the right to pay $K$ to get 1 euro. The premium $P(K,T)$ discussed here is in dollars and grants the right to pay 1 euro to get $K$. Thus the strike price $K$ is an exchange rate of USD per euro.

For example, let’s say $K=$ 0.80 USD/Euro at time 0. If at time $T$ the exchange rate is $x_T=$ 0.9 USD/Euro, the call buyer would want to exercise the option by paying 0.8 USD for 1 euro. If at time $T$ the exchange rate is $x_T=$ 0.7 USD/Euro, then the long put position would want to exercise the put by paying 1 euro to get 0.8 USD.

The relation (F1) indicates that the difference in the call and put premiums plus lending the present value of the strike price is the same as lending the present value of the amount in dollars (the domestic currency) that is required to buy 1 euro at time $T$.

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Put-call parity for bonds

For a zero-coupon bond, the forward price is simply the future value of the bond price. For a coupon paying bond, the future price has to reflect the value of the coupon payments. In the following parity relations, $B_0$ is the bond price at time 0. The amount $PV(\text{Coupons})$ is the present value of the coupon payments made during the life of the options.

$\text{ }$
Put-Call Parity – zero-coupon bond
$\displaystyle B_0=C(K,T)-P(K,T)+e^{-r T} K \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ (B1)$
$\text{ }$
$\displaystyle B_0-PV(\text{Coupons})=C(K,T)-P(K,T)+e^{-r T} K \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ (B2)$
$\text{ }$

Note that for the zero-coupon bond, the parity relation is similar to the one for non-dividend paying stock.

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Summary

The following is the list of all the asset specific put-call parity relations discussed in this post.

$\text{ }$
Forward/Futures
$\displaystyle e^{-r T} \ F_{0,T}=C(K,T)-P(K,T)+PV(K)$
$\text{ }$

Non-dividend paying stock
$\displaystyle S_0=C(K,T)-P(K,T)+e^{-r T} K$
$\text{ }$

Discrete dividend paying stock
$\displaystyle S_0-PV(\text{Div})=C(K,T)-P(K,T)+e^{-r T} K$
$\text{ }$

Continuous dividend paying stock
$\displaystyle S_0 e^{-\delta T}=C(K,T)-P(K,T)+e^{-r T} K$
$\text{ }$

Currency
$\displaystyle x_0 \ e^{-r_f T}=C(K,T)-P(K,T)+e^{-r T} K$
$\text{ }$

Bond
$\displaystyle B_0=C(K,T)-P(K,T)+e^{-r T} K$
$\text{ }$

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$\copyright \ \ 2015 \ \text{Dan Ma}$

## Basic insurance strategies – covered call and covered put

The use of options can be interpreted as buying or selling insurance. This post follows up on a previous post that focuses on two option strategies that can be interpreted as buying insurance – protective put and protective call. For every insurance buyer, there must be an insurance seller. In this post, we discuss two option strategies that are akin to selling insurance – covered call and covered put.

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Selling insurance against an asset position

The previous post discusses the strategies of protective put and protective call. Both of these are “buy insurance” strategies. A protective put consists of a long asset and a long put where the long put is purchased to protect against a fall in the prices of the long asset. A protective call consists of a short asset position and a long call where the long call option is purchased to protect against a rise in the prices of the asset being sold short. Both of these strategies are to buy an option to protect against the adverse price movement of the asset involved.

When an insurer sells an insurance policy, the insurer must have enough asset on hand to pay claims. Now we discuss two strategies where the investor or trader holds an asset position that can be used for paying claims on a sold option.

A covered call consists of a long asset and a short call. The insurance sold is in the form of a call option. The long asset gains in value when asset prices rise and the gains are used to cover the payments made by the call seller when the call buyer decides to exercise the call option. Therefore the covered call is to use the upside profit potential of the long asset to back up (or cover) the call option sold to the call buyer. The covered call strategy can be used by an investor or trader who believes that the long asset will appreciate further in the future but is willing to trade the long term upside potential for a short-term income (the call premium). This is especially true if the investor thinks that selling the long asset at the strike price of the call option will meet a substantial portion of his expected profit target.

A covered put consists of a short asset position and a short put. Here, the insurance sold is in the form of a put option. The short asset is used to back up (or cover) the put option sold to the put buyer. A short asset position is not something that is owned. How can a short asset position back up a put option? The short asset position gains in value when asset prices fall. A put option is exercised when the prices of the underlying asset fall. Thus a put option seller needs to pay claims exactly when the short asset position gains in value. Thus the gains in the short asset position are used to cover the payments made by the put seller when the put buyer decides the exercise the put option.

In this post, we examine covered call and covered put in greater details by examining their payoff diagrams and profit diagrams.

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Covered call

As mentioned above, a covered call is a position consisting of a long asset and a short call. Here the holder of the long asset sells a call against the long asset. Figure 1 is the payoff of the long asset. Figure 2 is the payoff of the short call. Figure 3 is the payoff of the covered call. Figure 4 is the profit of the covered call. The strike price in all the diagrams is $K$. We will see from Figure 4 that the covered call is a synthetic short put.

$\text{ }$

Figure 1 – Long Asset Payoff

$\text{ }$

Figure 1 is the payoff of the long asset position. When the asset prices are greater than the strike price $K$, the positive payoff is unlimited. The unlimited upside potential is used to pay claim when the seller of the call is required to pay claim to the call buyer.

$\text{ }$

Figure 2 – Short Call Payoff

$\text{ }$

Figure 2 is the payoff of the short call. This is the payoff of the call seller (i.e. the insurer). The call seller has negative payoff to the right of the strike price. The negative payoff occurs when the call buyer decides to exercise the call. The long asset payoff in Figure 1 is to cover this negative payoff.

$\text{ }$
Figure 3 – Long Asset + Short Call Payoff

$\text{ }$

Figure 3 is the payoff of the covered call, the result of combining Figure 1 and Figure 2. Unlike Figure 1, the long asset holder no longer has unlimited payoff to the right of the strike price. The payoff is now capped at the strike price $K$.

$\text{ }$
Figure 4 – Long Asset + Short Call Profit

$\text{ }$

Figure 4 is the profit of the covered call. The profit is the payoff less the cost of acquiring the position. At time 0, the cost is $S_0$ (the purchase price of the asset, an amount that is paid out) less $P$ (the option premium, an amount that is received). The future value of the cost of the covered call is then $S_0 e^{r T}-P e^{r T}$. The profit is then the payoff less this amount. The profit graph is in effect obtained by pressing down the payoff graph by the amount of $S_0 e^{r T}-P e^{r T}$. Because of the received option premium, $S_0 e^{r T}-P e^{r T}$ is less than the strike price $K$. As a result, the flat part of the profit graph is above the x-axis.

Without selling insurance (Figure 1), the profit potential of the long asset is unlimited. With the insurance liability (Figure 4), the profit potential is now capped at essentially at the call option premium. In effect the holder of a covered call simply sells the right for the long asset upside potential for cash received today (the option premium).

The strategy of a covered call may make sense if selling at the strike price can achieve a significant part of the profit target expected by the investor. Then the payoff from the strike price plus the call option premium may represent profit close to the expected target. Let’s look at a hypothetical example. Suppose that the stock owned by an investor was purchased at $60 a share. The investor believes that the stock has upside potential and the share price will rise to$70 in a year. The investor can then sell a call option with the strike price of $65 with an expiration of 6 months and with a call premium of$5. In exchange for a short-term income of the call option premium, the investor gives up the profit potential of $70 a share. If in 6 months, the share price is more than$65, then the investor will sell at $65 a share, producing a profit of$10 a share ($5 in share price appreciation and$5 call premium). If the share price is below the strike price is 6 months, the investor then pockets the \$5 premium.

Note the similarity between Figure 4 above and the Figure 11 in this previous post. Figure 11 in that previous post is the profit diagram of a short put. So the covered call (long asset + shot call) is also called a synthetic short put option since it has the same profit as a short put.

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Covered put

As indicated above, a covered put is to use the profit potential of a short asset position to cover the obligation of a sold put option. Figure 5 below is the profit of a short asset position. Figure 6 is the payoff of a short put option. Figure 7 is the payoff of the covered put. Figure 8 is the profit diagram of the covered put.

$\text{ }$

Figure 5 – Short Asset Payoff

$\text{ }$

Figure 5 is the payoff of the short asset position. Holder of a short asset position is concerned about rising prices of the asset. The holder of the short borrows the asset in a short sales and sells the asset immediately for cash, which is then accumulated at the risk-free rate. The short position will have to buy the asset back in the spot market at a future date to repay the lender. If the spot price at expiration is greater than the original sale price, then the short position will lose money. In fact the potential loss is unlimited.

$\text{ }$

Figure 6 – Short Put Payoff

$\text{ }$

Figure 6 is the payoff of a short put option. Recall that the short put payoff is from the perspective of the seller of the put option. When the price of the underlying asset is below the strike price, the seller has the obligation to sell at the strike price (thus experiencing a loss). When the asset price is above the strike price, the put option expires worthless.

$\text{ }$

Figure 7 – Short Asset + Short Put Payoff

$\text{ }$

Figure 7 is the payoff of the covered call. With the covered call, the holder of the short asset can no longer profit by paying a price lower than the strike price for the asset to repay the lender. Instead he has to pay the strike price (this is the flat part of Figure 7). To the right of the strike price, the covered call continues to have the potential for unlimited loss.

$\text{ }$

Figure 8 – Short Asset + Short Put Profit

$\text{ }$

Figure 8 is the profit of the covered put, which indicates the profit is essentially the option premium received by selling the put option. Without selling the insurance (Figure 5), the short asset position has good profit potential when prices fall. With selling the insurance, the profit potential to the left of the strike price is limited to the option premium. The covered put is in effect to trade the profit potential (when prices are low) with a known put option premium.

Compare Figure 8 above with Figure 5 in this previous post. Both profit diagrams are of the same shape. Figure 5 in the previous post is the profit diagram of a short call. So the combined position of short asset + short put is called a synthetic short call.

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Synthetic put and call

Just a couple of more observations to make about synthetic put and synthetic call.

Note that Figure 3 (the payoff of long asset + short call) also resembles the payoff of a short put option, except that the level part of the payoff is not at the x-axis. So Figure 3 is the lifting up of the usual short put option payoff by a uniform amount. That uniform amount can be interpreted as the payoff of a long zero-coupon bond. Thus we have the following relationship.

$\text{ }$
payoff of “long asset + short call” = payoff of “short put + zero-coupon bond”
$\text{ }$

Adding a bond lifts the payoff graph. However, adding a bond to a position does not change the profit. To see this, simply subtract the cost of acquiring the position from the payoff. You will see that for the bond, the same amount appears in both the cost and the payoff. Thus we have:

$\text{ }$
profit of “long asset + short call” = profit of “short put”
$\text{ }$

As mentioned earlier, the above relationship indicates that the combined position of long asset + short call can be viewed as a synthetic short put. We now see that the covered call is identical to a short put.

Now similar thing is going on in a covered put. Note that Figure 7 resembles the payoff of a short call except that it is the pressing down of the payoff of a usual short call. We can think of this pressing down as a borrowing. Thus we have:

$\text{ }$
payoff of “short asset + short put” = payoff of “short call – zero-coupon bond”
$\text{ }$

Adding a bond means lending and subtracting a bond means borrowing. As mentioned before, adding or subtracting a bond lift or depress the payoff graph but does not change the profit graph. We have:

$\text{ }$
profit of “short asset + short put” = profit of “short call”
$\text{ }$

The above relationship is the basis for calling “short asset + short put” as a synthetic short call.

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$\copyright \ \ 2015 \ \text{Dan Ma}$

## Basic insurance strategies – protective put and protective call

This post follows up on a previous post, which is an introductory discussion on options. In this post, we focus on the two basic strategies of using options as insurance – protective put and protective call. These two strategies are for investors or traders who want to buy insurance to protect profits that come from holding either a long or short position. For every insurance buyer, there must be an insurance seller. In the next post, we discuss covered call and covered put – basic strategies for investors or traders who want to sell insurance protection.

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Option strategies that are insurance protection

Suppose that an investor has been holding an asset that has gained in value. The long asset position held by this investor will suffer a loss if prices fall. A long put option (a purchased put) has positive payoff when prices are less than the strike price. Buying a put option will guarantee a minimum sale price (the strike price of the put option) should the investor wishes to sell the asset at a future date. Thus the risk management strategy of buying a put option to guard against the loss of a long position is called a protective put.

A protective call deals with an opposite situation. Suppose an investor or trader is holding a short position on an asset (e.g. the investor has short sold a stock). The short asset position held by this investor will suffer a loss if prices increase. A purchased call option has positive payoff when the asset prices are greater than the strike price. When the investor buys a call option with the same underlying asset, the strike price is in effect a minimum purchased price of the asset should there be a price increase, thus keeping the loss at a minimum. Thus the risk management strategy of buying a call option to guard against the loss of a short position is called a protective call.

Protective puts and protective calls are basic insurance strategies that can be used to protect profits from either holding a long asset position or a short position. Both of these strategies will minimize the loss in the event that the prices of the asset position move in the wrong direction. Of course, the insurance protection comes at a cost in the form of an option premium, which is a cash fee paid by the buyer to the seller at the time the option contract is made. In the remainder of the post, we examine the protective put and the protective call in greater details by examining the payoff and profit diagrams.

The put and call considered here are European options, i.e., they can be exercised only at expiration.

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Protective put

The protective put consists of a long asset position (e.g. owning a stock) and a long put option on the same asset. Our goal is to examine the payoff and profit of this combined position. We can then make some observations based on the profit diagram. Figure 1 is the payoff of the long asset. Figure 2 is the payoff of the long put option. Figure 3 is the payoff of the combined position. Figure 4 is the profit of long asset + long put. The strike price in all the diagrams is $K$. Instead of using a numerical example to anchor the diagrams, we believe that the following diagrams of payoff and the profit are clear. In fact, getting bogged down in a numerical example may make it harder to see the general idea. Asking questions such as – what happens when the asset is less than $K$, etc – will make the diagrams clear. In fact, reading the diagrams is a good concept check. An even better practice is to draw the payoff and profit diagrams on paper.

$\text{ }$

Figure 1 – Long Asset Payoff

$\text{ }$

Figure 1 is the payoff of the long asset. The strike price $K$ has no effect on the payoff of the long asset (Figure 1). The payoff of an asset is simply the value of the asset at a point in time. Thus the payoff is simply the asset price at a target date. The higher the asset price, the higher the payoff.

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Figure 2 – Long Put Payoff

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Figure 2 is the payoff of the long put option. For the long put, the payoff is $K-S_T$ when it makes sense for the put option buyer to exercise. Thus the payoff is positive to the left of $K$. To the right of $K$, the put option expires worthless, thus the payoff is 0. The sum of Figure 1 and Figure 2 gives Figure 3.

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Figure 3 – Long Asset Long Put Combined Payoff

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Figure 3 is the payoff of Long Asset + Long Put. The payoff to the right of the strike price $K$ is flat, which is a sign of the insurance at work. The positive payoff of the long put neutralizes the effect of falling prices of the long asset, minimizing the loss from holding a long asset when the prices go south. This position of long asset + long put will enjoy the upside potential in the event that prices go up. Of course, such as good insurance product is not free. The next diagram will take cost into account. First, the following formula shows the payoff of long asset + long put.

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$\displaystyle \text{payoff of long asset + long put}=\left\{\begin{matrix} \displaystyle K&\ \ \ \ \ \ S_T \le K \\{\text{ }}& \\ S_T&\ \ \ \ \ \ S_T >K \end{matrix}\right.$

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Figure 4 – Long Asset Long Put Combined Profit

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Figure 4 is the profit of long asset + long put. Recall that the profit of a position is the payoff less the cost of acquiring that position. What is the cost of acquiring a long asset and a long put? The cost of the long asset is $S_0 e^{r T}$, the future value of the price paid at time 0. The cost of the long put is $P e^{r T}$, where $P$ is the put option premium paid by the buyer to the seller at time 0. Thus the cost of the long asset + long put is $(S_0+P) e^{r T}$. As a result, the profit graph is Figure 4 is obtained by pressing down the payoff in Figure 3 by the amount of the cost. The cost of the position is likely to be more than the strike price $K$. This is why $K-\text{Cost}$ in Figure 4 is negative.

Without the insurance (Figure 1), the long asset position will suffer substantial loss in the event that the prices are low. With insurance (Figure 4), the potential loss for the long asset position is essentially the put option premium. But the long asset position still enjoys the upside profit potential (less the option premium).

Another observation that can be made about Figure 4 is that its shape is very similar to the profit of a long call option (compare Figure 4 above with the Figure 1 in this previous post). The profit diagram of long asset + long put does not merely resemble the profit of a long call (with the same strike price); it is identical.

Based on Figure 4, the investment strategy of long asset + long put mimics the profit of the long call position (with the same strike price). Thus the position of long asset + long call is called a synthetic call option.

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Protective call

The protective call consists of a short asset position (e.g. shorting a stock) and a long call option on the same asset. We now examine the payoff and profit of this combined position. Figure 5 is the payoff of the short asset. Figure 6 is the payoff of the long call option. Figure 7 is the payoff of short asset + long call. Figure 8 is the profit of short asset + long call. The strike price in all the diagrams is $K$. From Figure 8, we will see that the combined position is a synthetic put option.

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Figure 5 – Short Asset Payoff

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Figure 5 is the payoff of the short asset position. Holder of a short asset position is concerned about rising prices of the asset. The holder of the short borrows the asset in a short sales and sells the asset immediately for cash, which is then accumulated at the risk-free rate. The short position will have to buy the asset back in the spot market at a future date to repay the lender. If the spot price at expiration is greater than the original sale price, then the short position will lose money. In fact the potential loss is unlimited.

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Figure 6 – Long Call Payoff

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Figure 6 is the payoff of the long call position. When the spot price at expiration is less than the strike price $K$, the call option expires worthless. When the spot price at expiration is greater than the strike price $K$, the payoff is $S_T-K$.

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Figure 7 – Short Asset + Long Call Payoff

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Figure 7 is the payoff of the combined position of a short asset and a long call. The payoff of the combined position is flat to the right of the strike price. This is a sign of the insurance at work. The upside potential of the short call is limiting the loss of the short asset position. The positive payoff of the long call is $S_T-K$. The payoff of the short asset is $-S_T$ when price is greater than the strike price. Then the combined payoff is $-K$ when price is greater than the strike price. To further clarify, the following is the payoff of the combined position.

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$\displaystyle \text{payoff of short asset + long put}=\left\{\begin{matrix} \displaystyle -S_T&\ \ \ \ \ \ S_T \le K \\{\text{ }}& \\ -K&\ \ \ \ \ \ S_T >K \end{matrix}\right.$

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Figure 8 – Short Asset + Long Call Profit

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Figure 8 is the profit of short asset + long call. To derive the profit, we need to subtract the cost of acquiring the combined position from the payoff. The profit graph is Figure 8 is the result of lifting up the payoff graph. That suggests that in this case the profit is the payoff plus a positive amount. This is indeed correct since the cost of acquiring the position is a negative number. Thus subtracting the cost from the payoff is in effect adding a positive number.

To see the above point, the cost of acquiring the initial position is a positive number if it is a cash outflow (you pay to buy an asset) and is a negative number if it is a cash inflow (you sell an asset). In a short position, you borrow the asset and sell it to get cash, which is $-S_0 e^{r T}$ in this calculation. There is also the purchase of a call. Thus the total cost is $-S_0 e^{r T}+P e^{r T}$, which is likely a negative amount. So subtracting this negative cost from the payoff has the effect of lifting up the payoff graph.

Without the insurance of a long call (Figure 5), the short asset position has unlimited loss. With insurance (Figure 8), the loss of the short asset position is minimized, essentially the call option premium. The short asset position still enjoys the profit potential should asset prices fall (less the option premium).

Compare the above Figure 8 with the Figure 8 in this previous post, we see that they have the same shape. This is not coincidence. Both positions have the same profit. Thus the combined position of a short asset and a long call option is called a synthetic long put option since both have the same profit diagrams.

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Synthetic put and call

Just a couple of more observations to make about synthetic put and synthetic call.

Note that Figure 3 (the payoff of long asset + long put) also resembles the payoff of a long call option, except that the level part of the payoff is not at the x-axis. So Figure 3 is the lifting up of the usual long call option payoff by a uniform amount. That uniform amount can be interpreted as the payoff of a zero-coupon bond. Thus we have the following relationship.

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payoff of “long asset + long put” = payoff of “long call + zero-coupon bond”
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Adding a bond lifts the payoff graph. However, adding a bond to a position does not change the profit. To see this, simply subtract the cost of acquiring the position from the payoff. You will see that for the bond, the same amount appears in both the cost and the payoff. Thus we have:

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profit of “long asset + long put” = profit of “long call”
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As mentioned earlier, the above relationship indicates that the combined position of long asset + long put can be viewed as a synthetic long call. We now see that the protective put is identical to a long call.

Now similar thing is going on in a protective call. Note that Figure 7 resembles the payoff of a long put except that it is the pressing down of the payoff of a usual long put. We can think of this pressing down as a borrowing. Thus we have:

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payoff of “short asset + long call” = payoff of “long put – zero-coupon bond”
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Adding a bond means lending and subtracting a bond means borrowing. As mentioned before, adding or subtracting a bond lift or depress the payoff graph but does not change the profit graph. We have:

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profit of “short asset + long call” = profit of “long put”
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The above relationship is the basis for calling “short asset + long call” as a synthetic long put.

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$\copyright \ \ 2015 \ \text{Dan Ma}$