## Options Education

### Understanding Put-Call Parity and Synthetics - Part Two

...continued from Part One

Married Put Cont...
So if the married put is a more expensive endeavor than the long call because of
the interest paid on the investment portion that is below the strike, why would anyone
intensiveólong call?

Given the additional interest expense, they would rather buy the call. This relates to the concept of arbitrage. Given two effectively identical choices,rational traders will choose to buy the less expensive alternative. The market as a wholewould buy the calls, creating demand which would cause upward price pressure on thecall. The price of the call would rise until its interest advantage over the married put wasgone.

In a robust market with many savvy traders, arbitrage opportunities donít exist for very long. It is possible to mathematically state the equilibrium point toward which the
market forces the prices of call and put options by use of the put-call parity. The put-call parity equation states:

• c + PV(x) = p + s
where
• c is the call premium
• PV(x) is the present value of the strike price
• p is the put premium
• s is the stock price.
Another, less academic and more trader-friendly way of stating this equation is

• Call + Strike ñ Interest = Put + Stock

where Interest is calculated as

• Interest = Strike x Interest Rate x (Days to Expiration/365)
The two versions of the put-call parity stated here hold true for European options on nonñdividend-paying stocks.

Dividends
Another difference between call and married-put values is dividends. A call option does
not extend to its owner the right to receive a dividend payment. Traders, however, who
are long a put and long stock are entitled to a dividend if it is the corporationís policy to
distribute dividends to its shareholders.

An adjustment must be made to the put-call parity to account for the possibility of a dividend payment. The equation must be adjusted to account for the absence of dividends paid to call holders. For a dividend-paying stock, the put-call parity states
•   Call + Strike ñ Interest + Dividend = Put + Stock
The interest advantage and dividend disadvantage of owning a call is removed
from the market by arbitrageurs. Ultimately, that is what is expressed in the put-call
parity. Itís a way to measure the point at which the arbitrage opportunity ceases to exist. When interest and dividends are factored in, a long call is an equal position to a long putpaired with long stock. In options nomenclature, a long put with long stock is a syntheticlong call. Algebraically rearranging the above equation:
•   Call = Put + Stock ñ Strike + Interest ñ Dividend

The interest and dividend variables in this equation are often referred to as the
basis. From this equation, other synthetic relationships can be algebraically derived, like the synthetic long put.
• Put = Call ñ Stock + Strike ñ Interest + Dividend
A synthetic long put is created by buying a call and selling (short) stock. The at-expiration diagrams in FIGURE 6.2 show identical payouts for these two trades.

Figure 6.2   Long Put vs. Long Call + Short Stock

Synthetics
The concept of synthetics can become more approachable when studied from the
perspective of delta as well. Take the 50-strike put and call listed on a \$50 stock. A
general rule of thumb in the put-call pair is that the call delta plus the put delta equals
1.00 when the signs are ignored. If the 50 put in this example has a ñ0.45 delta, the 50
call will have a 0.55 delta. By combining the long call (0.55 delta) with short stock (ñ1.00delta), we get a synthetic long put with a ñ0.45 delta, just like the actual put.

Thedirectional risk is the same for the synthetic put and the actual put.
A synthetic short put can be created by selling a call of the same month and strike
and buying stock on a share-for-share basis. This is indicated mathematically by
multiplying both sides of the put-call parity equation by ñ1:
• ñPut = ñCall + Stock ñStrike + Interest ñDividend
to be continued in Part Three
"

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