Are the price of calls and puts related?
Today, we are going to explore an important relationship between the price of call and put options that is often times misunderstood, or just plain ignored by retail option traders. Understanding this concept is essential to all levels of option traders.
Have you ever noticed call and put options with the same strike price and expiration date very rarely trade at the same price? The call is sometimes more than the put or sometimes the put is more than the call. There is a reason why this occurs but it is often misinterpreted by novice investors as a bullish or bearish sign for the underlying stock. It has nothing to do with the potential market direction of the stock, and everything to do with synthetic relationships and carry costs of a position. To start on the right foot let’s define these two terms.
Definition: Syn·thet·ic (sn-thtk) - A financial instrument that is created artificially by simulating the risk and rewards of that instrument with the combined features of a collection of other assets.
Definition: Carry Costs (kr kôsts) - Costs incurred as a result of an investment position. These costs can include financial costs, interest on loans used to purchase a the investment, and dividends that are expected to paid by some securities.
The core concept of why we will be using these terms today is that some option strategies have very similar risks and rewards to an entirely different strategy except for the carry costs of the position. Bottom line, if you include carry costs when pricing option contracts you can find two totally different strategies that are truly synthetic versions of each other. To prove this let’s ponder this question.
Can X actually equal Y?
Sometimes, yes. Consider the risk, rewards and market outlook of the following pair: Long Stock plus a Long Put. In many ways, this resembles holding just a long call: you benefit if the market rises, and you have limited and known risk if the market falls.
The profit and loss graphs below make this similarity a little clearer. The X-axis refers to the stock price at expiration, and the y-axis refers to the profit or loss for each position. Let's assume the stock is at 80, the interest rate is 5.3613%, volatility is 27.95% and expiration is 61 days away, with no dividend upcoming. Let's also assume we're using the ATM put and call in this example, with a strike price for each of 80. (Note: The interest rate is large for the current market environment, but it helps with the understanding of the concept.)
The first graph shows the P&L of a long stock position (gray), the P&L for a long put (green), and the P&L for the combined position (red). Compare this red line with the second graph, which depicts the simple P&L of the long call (blue). It's easy to see that buying the protective put and buying the call results in a very similar P&L at expiration.
Before we run away and say they're not just similar but identical, let's graph both on the same graph and see if they are any subtle differences.
When we graph each position on top of the other (protective put in red and long call in blue), the point where each strategy crosses the X-axis is called the breakeven point at expiration. Notice the small difference in the breakeven number of these two positions (83.35 vs 84). That's because the put is trading for a little less than the call. Why? It has to or there would be an arbitrage situation. Let me explain: we have two strategies that are mostly the same as far as risk and reward are concerned, but not with regard to carry costs.
Quick interruption for another question:
Using a similar example to the one above, lets imagine you had enough money to place either trade. You could either buy the protective put or just buy the call outright. But in this example let’s say the 80 strike put and 80 strike call were trading for the same amount, which trade would you use your funds on: a protective put or a long call? I hope you said long call, because if the 80 strike put and 80 strike call are exactly the same price, it makes sense to choose the call. With the call, you won't have to spend additional money to buy the stock (remember, a protective put is a long put PLUS long stock), and because the put and call are the same price the breakevens would be exactly the same number for either strategy (as opposed to the positions portrayed in the graphs above).
Back to the original example:
As noted in the graphs above the breakevens are not exactly the same, so why? Since both trades have basically the same risk and reward, to make them truly comparable we have to even things out. How? If we take the carry-cost of the stock out of the price of the put, then everything comes into equal balance. Here is the quick and dirty math involved:
Cost of stock = 100 x 80 = 8000
Carry-cost of stock = 8000 x .053613 = 428.90
If we didn’t have to buy the stock we could put this 8000 dollars into an interest-bearing account at 5.3613% (for this example) and we would earn $428.90 annually in interest. By holding long stock, we're forgoing that interest income: that's what "cost-to-carry" actually means.
Translate to days = 428.90/365 = 1.17 of interest income lost per day
Carry-costs over life of the option positions = 1.17 x 61 days to expiration = 71.37/100 = 0.71 or 71 cents
Compare this number, 0.71 to the different between breakevens in our graph above, which is 0.75 (84 - 83.35 = 0.75). That's pretty much identical if you account for rounding errors. Even though 75 cents might seem like a small discrepancy, it's an important one. In fact, this relationship has to hold true or institutional traders would buy the cheap strategy and sell the expensive strategy and collect money above and beyond the carry-cost with no additional risk. That's the arbitrage opportunity I referred to before.
Time to play market-maker:
To understand why this matters, put on your mesh jacket and imagine you're a market-maker for a second. An apparently tiny difference like this matters more to market makers than retail customers because of their role to provide liquidity to the marketplace. That role often boxes them into positions they didn't plan on holding, so they're always considering alternative "ways out" of various trades. This is why knowing how to create a position synthetically is a must for market makers.
Market makers are also looking for the smallest edge they can possibly get. Given their huge size and very low transaction costs, it can make financial sense for them to find a trade that makes them a penny and try to make that penny 10,000 times in a single day. This explains why calls and puts on the same strike line and with the same expiration don’t usually trade for the same price.
Now let us toss a stock dividend into the mix:
So what if a stock above pays a dividend before the expiration of the option contacts? Better yet, what if it is a big dividend - like $1.00 per share? A dollar per share paid dividend paid by the stock is more than the interest cost that could be earned by keeping the $8,000 in an interest-bearing account over the life of the option contracts. We already determined the interest earned on the cash to be about $71, a dollar dividend on 100 shares of stock would net $100.
If this is the case, it becomes more beneficial to own the stock outright than have the cash. This implies it is cheaper overall to carry the long stock and long put position than it is to carry the long call position. Therefore, the put has to trade for more than the call in this scenario to “balance” things out.
If you would like to run your own examples inside your TradeKing account, just use the options calculator under the Tools menu (after you are signed in) and put a stock in that pays a dividend. Remove the dividend, maybe change the interest rate and hit “re-calculate” and note what happens to the theoretical price of the call and put on the right hand side.
Tacked another misunderstanding in the option marketplace:
That's it for today, folks. Next we'll explore other synthetic relationships that exist in the complex world of option trading.
TradeKing Options Guy and Senior Option Analyst
Follow Brian on Twitter or visit TradeKing on Facebook and YouTube.
Options involve risk and are not suitable for all investors. For more information, please review the Characteristics and Risks of Standard Options brochure available at www.tradeking.com/ODDbefore you begin trading options. Options investors may lose the entire amount of their investment in a relatively short period of time.
Multiple leg options strategies involve additional risks and multiple commissions, and may result in complex tax treatments. Please consult a tax professional prior to implementing these strategies.
While Delta represents the consensus of the marketplace as to the theoretical price movement of the option relative to the underlying security there is no guarantee that this forecast will be correct.
While Gamma represents the consensus of the marketplace as to the theoretical rate of change of Delta relative to the underlying security there is no guarantee that this forecast will be correct.
While Theta represents the consensus of the marketplace as to the amount a theoretical option's price will change for a corresponding one-unit (day) change in the days to expiration of the option contract there is no guarantee that this forecast will be correct.
While Alpha represents the consensus of the marketplace as to the relationship between gamma and theta there is no guarantee that this forecast will be correct.
While Vega represents the consensus of the marketplace as to the amount a theoretical option's price will change for a corresponding one-unit (point) change the implied volatility of the option contract there is no guarantee that this forecast will be correct.
While Rho represents the consensus of the marketplace as to the amount a theoretical option's price will change for a corresponding one-unit (percent) change in the interest rate used to price the option contract there is no guarantee that this forecast will be correct.
While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.
System response and access times may vary due to market conditions, system performance and other factors.
All investments involve risk, losses may exceed the principal invested, and the past performance does not guarantee future results or returns. TradeKing provides self-directed investors with discount brokerage services, and does not make recommendations or offer investment, financial, legal or tax advice. You alone are responsible for evaluating the merits and risks associated with the use of TradeKing's systems, services or products. Content, research, tools, and stock or option symbols are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy.