Put and Call Options: Understanding Put-Call Parity and Arbitrage Opportunities

Category : Put and Call Options | Sub Category : Put-Call Parity and Arbitrage Posted on 2023-07-07 21:24:53

Put and Call Options: Understanding Put-Call Parity and Arbitrage Opportunities
Introduction:
Put and call options are financial instruments that give traders and investors the opportunity to speculate and manage risk. It is important to understand the concept of put-call parity and how it can be exploited through arbitrage strategies when considering put and call options.
Understanding Put and Call options is important.
Put and call options are contracts that grant the holder the right to buy or sell a specific underlying asset at a certain price within a certain period, but not the obligation to do so. These options are used in the financial markets to speculate on price movements, hedge risk and generate income.
Put-Call Parity:
Put-call parity is a relationship between the strike price and the expiration date of put and call options. The relationship between the premiums paid for options and the current price of the underlying asset is established. The cost of buying a call option with the strike price and the current price of the underlying asset are equal.
Put-call parity can be expressed as:
The call option premium, put option premium, and current price of the underlying asset are all referred to as P + S.
There are opportunities for arbitrary behavior.
There is an opportunity for risk-free arbitrage when there is a discrepancy in the prices of put and call options. Mispricing can be used to lock in profits without taking market risk.
There are two main strategies for doing this.
1 Conversion:
The trader buys a put option, sells a call option, and buys the underlying asset in the conversion strategy. They can take advantage of the mispricing and make risk-free profits. An opportunity arises if the put option is cheaper than the asset if the put-call parity is violated.
2 Reversal:
The reversal strategy is different from the conversion strategy. The trader simultaneously buys a call option, sells a put option, and sells the underlying asset. The reversal strategy is similar to the conversion strategy in that it exploits the mispricing between put and call options to generate risk-free profits. An opportunity exists when the put option costs less than the call option.
Conclusion
Understanding put-call parity is important for traders and investors. By exploiting mispricing between put and call options, savvy individuals can make risk-free profits. Market participants would act quickly to eliminate any significant discrepancies, so opportunities for arbitrage are typically short-lived.