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Put-Call Parity
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What is 'Put-Call Parity'

Put-call parity is aprinciple that defines the relationship between the price of
European put options and European call options of the same class, that is,
with the same underlying asset, strike price and expiration date. Put-call
parity states that simultaneously holding a short European put and long
European call of the same class will deliver the same return as holding one

forward contract on the same underlying asset, with the same expiration and
a forward price equal to the option's strike price. If the prices of the put and
call options diverge so that this relationship does not hold, an arbitrage
opportunity exists, meaning that sophisticated traders can earn a
theoretically risk-free profit. Such opportunities are uncommon and short-
lived in liquid markets.
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The equation expressing put-call parity is:

C + PV(x) = P + S

where:

C = price of the European call option

PV(x) = the present value of the strike price (x), discountedfrom the value on the expiration date at
the risk-free rate

P = price of the European put

Trading Center
S = spot price, thecurrent market value of the underlying asset

BREAKING DOWN 'Put-Call Parity'

Put-call parity applies only to European options, which can only be exercised on the expiration date,
and not American ones, which can be exercised before.

Say that you purchase a European call option for TCKR stock. The expiration date is one year from
now, the strike price is $15, and purchasing the call costs you $5. This contract gives you the right
but not the obligationto purchase TCKR stock on the expiration date for $15, whatever the market
price might be. If one year from now, TCKR is trading at $10, you will not exercise the option. If, on
the other hand, TCKR is trading at $20 per share, you will exercise the option, buy TCKR at $15 and
break even, since you paid $5 for the option initially. Any amount TCKR goes above $20 is pure profit,
assuming zero transaction fees.

Say you also sell (or "write" or "short") a European put option for TCKR stock. The expiration date,
strike price and cost of the option are the same. You receive the $5 price of the option, rather than
paying it, and it is not up to you to exercise or not exercise the option, since you don't own it. The
buyer has purchased the right, but not the obligation, to sell you TCKR stock at the strike price; you
are obligated to take that deal, whatever TCKR's market share price. So if TCKR trades at $10 a year
from now, the buyer will sell you the stock at $15, and you will both break even: you already made $5
from selling the put, making up your shortfall, while they already spent $5 to buy it, eating up their
gain. If TCKR trades at $15 or above, you have made $5 and only $5, since the other party will not
exercise the option. If TCKR trades below $10, you will lose moneyup to $10, if TCKR goes to zero.

The profit or loss on these positions for di erent TCKR stock prices is graphed below. Notice that if
you add the profit or loss on the long call to that of the short put, you make or lose exactly what you
would have if you had simply signed a forward contract for TCKR stock at $15, expiring in one year. If
shares are going for less than $15, you lose money. If they are going for more, you gain. Again, this
scenario ignores all transaction fees.

Put Another Way

Another way to imagine put-call parity is to compare the performance of a protective put and a
fiduciary call of the same class. A protective put is a long stock position combined with a long put,
which acts to limit the downside of holding the stock. A fiduciary call is a long call combined with
cash equal to the present value (adjusted for the discount rate) of the strike price; this ensures the
investor has enough cash to exercise the option on the expiration date. Before we said that TCKR
puts and calls with a strike price of $15 expiring in one year both traded at $5, but let's assume for a
second that they trade for free:
[Although arbitrage opportunities are hard to find, if you're interested in the European options
market, you may at least want to know where to look. Learn the what options traders know, the
basics of puts and call, and how to get the odds in your favor with Investopedia Academy's Options
For Beginners Course.]

Put-Call Parity And Arbitrage

In the two graphs above, they-axis represents the value of the portfolio, not the profit or loss,
because we're assuming that traders are giving options away. They are not, however, and the prices
of European put and call options are ultimately governed by put-call parity. In a theoretical, perfectly
e icient market, the prices for European put and call options would be governed by the equation:

C + PV(x) = P + S

Let's say that the risk-free rate is 4% and that TCKR stock is currently trading at $10. Let's continue to
ignore transaction fees and assume that TCKR doesn't pay a dividend. For TCKR options expiring in
one year with a strike price of $15 we have:

C + (15 1.04) = P + 10

4.42 = P - C

In this hypothetical market, TCKR puts should be trading at a $4.42 premium to their corresponding
calls. This makes intuitive sense: with TCKR trading at just 67% of the strike price, the bullish call
seems to have the longer odds. Let's say this is not the case, though: for whatever reason, the puts
are trading at $12, the calls at $7.

7 + 14.42 < 12 + 10

21.42 fiduciary call < 22 protected put

When one side of the put-call parity equation is greater than the other, this representsan arbitrage
opportunity. You can "sell" the more expensive side of the equation and buy the cheaper side to
make, for all intents and purposes, a risk-free profit. In practice, this means selling a put, shorting the
stock, buying a call and buying the risk-free asset (TIPS, for example).

In reality, opportunities for arbitrage are short-lived and di icult to find. In addition, the margins
they o er may be so thin that an enormous amount of capital is required to take advantage of them.
Put On A Call
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One of the four types of compound options, this is a "put" option on an underlying "call" option. The
buyer of a put on a call has the right but not the obligation to sell the underlying call option on the
expiration date. This type of option is used when leverage is desired, and the trader is bearish on the
underlying asset. The value of a put on a call changes in inverse proportion to the price of the
underlying asset, i.e. it decreases as the asset price increases, and increases as the asset price
decreases. Also known as a split-fee option.

BREAKING DOWN 'Put On A Call'

A put on a call has two strike prices and two expiration dates, one for the initial put option and the
other for the underlying call option. Note that compound options are generally European-style
exercise, which means that they can only be exercised on the expiration date.

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