Options are derivative instruments. One of the reasons trading options and investing in them is so much fun is that it resembles a game of chess. Throughout the life of an option, there are numerous opportunities; they can enhance or destroy the value of a position.
What is the equality between call and put options?
The equality between call and put options is a concept that anyone involved in options markets should understand. The equality is functional parity. The genius of options theory and structure is that there are two complementary tools for pricing and valuation: call options and put options.
By knowing the value of a put option, you can quickly find the value of the corresponding call option with the same strike price and expiration date. There are many reasons why this is important. It can highlight winning opportunities that arise when option prices are incorrect. It can also help you estimate the relative value of an option.
There are two types of options: American and European. American options can be exercised at any time during their life. European options can only be exercised at the expiration date of the options. In most cases, the equality between call and put options works perfectly with European options only.
What are examples of the equality between call and put options?
Option prices have two components: intrinsic value and time value (or extrinsic value). Intrinsic value is the part of the option that is in the money. For example, a call option with a strike price of $15 on silver with a premium of $1.50 when the price of silver is $16 has an intrinsic value of $1; therefore, it also has $0.50 in time value.
What about a call option with a strike price of $17 on silver that has a premium of $0.50 when the price of silver is $16? It will have no intrinsic value and will only have $0.50 in time value. Thus, options in the money contain intrinsic value and time value; out-of-the-money options contain only time value. The equality between call and put options is an extension of these concepts.
If the price of gold is trading at $1200 per ounce in June, then a call option with a strike price of $1100 with a premium of $140 has an intrinsic value of $100 and a time value of $40. The concept of equality between call and put options tells us that the value of a put option with a strike price of $1100 in June will be $40.
Here is another example: if cocoa is trading at $3000 per ton in July, then a put option with a strike price of $3300 in July with a premium of $325 per ton will unequivocally tell us that the value of a call option with a strike price of $3300 in July is $25 per ton. As can be imagined, call and put options that are at the same price (strike prices equal to the current futures price) with the same expiration date and strike price (called a straddle) will trade at the same price; both contain only time value.
What are the formulas?
To tie all this together, there are some simple formulas to remember for European-style options: long call + short futures = long put (same strike price and expiration date), long put + long futures = long call (same strike price and expiration date), long call + short put = long futures (same strike price and expiration date), long put + short call = short futures (same strike price and expiration date).
Conclusion
Options are amazing instruments. Understanding options and the equality between call and put options will enhance your market knowledge. It can open new doors for profitability and risk management.
Equality
Between call and put options is a feature of options markets. This applies not only in commodities but in all asset markets where options markets thrive. Spend some time learning to understand the equality between call and put options. It’s a concept that will put you in a position to understand the markets better than most other market participants, giving you an edge over the competition.
Success in the markets is often a result of the ability to see market variance or mispricing ahead of others. The more you know, the greater your chances of success.
Source: https://www.thebalancemoney.com/options-the-concept-of-put-call-parity-808888
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