Option trading basics teaches us that the concept of put-call parity means that for every call option price, the corresponding put option (same stock, strike and expiration) will have an implied value. For example, if Company BCI is trading at $50.00 per share, if the $50 call option generated $1.50, the put option would also be expected to generate $1.50. The reason for this is that if there was a movement away from this parity there would be an arbitrage opportunity where one option could be bought and the other sold for a risk-free profit. Now this concept applies to European style options. Since, in reality, we are dealing with American style options, dividends and interest rates need to be factored in. As an example, if the $50.00 stock had an ex-dividend date prior to expiration and the dividend amount was $1.00, the call option would be worth less and the put option more because share price will drop by the dividend amount on the ex-date. This will impact calls negatively and puts positively.
The “moneyness” of options
Another factor that impacts the value of the option premiums is the “moneyness” of the option or the relationship between the strike price and the market value of the stock. In the example below, Taser Intl Inc. (TASR) was trading at $30.90 on 7/24/2015. That would make the $31.00 strike very close to at-the-money. But what about the $30.00 strike? Well that strike is in-the-money for calls and out-of-the-money for puts. From this perspective we would expect the call option to be more expensive because of the intrinsic value component. Let’s view an options chain to make this concept come alive:
Let’s first look at the $31.00 strike price (brown row) which is very close to at-the-money. The blue arrows highlight the fact that the option-pricing is the same thereby confirming the following put-call parity rule:
Buy stock + buy put = Buy call
If there was a disparity between the put and call premiums at this strike it would set up an arbitrage opportunity for market makers to take advantage of and generate a risk-free profit…not fair to us.
Next, let’s have a look at the $30.00 strike price in the yellow-highlighted row. This strike is considered in-the-money for calls but out-of-the-money for puts so we would anticipate a higher premium for the call option because of the intrinsic value component of the option premium. This is confirmed with a bid price of $2.40 for the call and $1.45 for the put as shown with the green arrows. Next, let’s calculate the time value for the call option:
Time value = Total premium – intrinsic value
Time value = $2.40 – $0.90 = $1.50
Now the two time values are in sync, the call at $1.50 and the put at $1.45.
Put-call parity is an important concept in option pricing as it prevents unfair arbitrage opportunities. If these opportunities did present themselves, it would benefit market-makers, not us. There are factors that would create a discrepancy between the same strike prices for the same stock and expiration. These include interest rate factors, dividends and the moneyness of options. Understanding these concepts will elevate us the elite status as covered call writers and put-sellers.
Blue Collar Scholar Competition: Great prizes and a worthy charity
HURRY: CONTEST DEADLINE IS NOVEMBER 30th
Contest leaders as of Friday’s market close (S&P 500 reading at the end of the year)
Sample Commentary from Chris:
“With the economy getting back on its feet, I think the markets will see more consumer confidence. With the potential rate hike everyone seems to be talking about though, it might suffer a minor setback. I think it will rise but a conservative rise”.
Thanks for the great response we’ve had to this event. Keep those entry forms coming. We allow two per email address and the deadline is MONDAY November 30th.
Next live appearance
Saturday January 23rd, 2016: Kansas City, Missouri
9 AM – 12:30 PM
Matt Ross Community Center
All files in the “Resources/Downloads” section of the Premium site have been updated and dated as shown in the screenshot below:
Markets were tranquil during this holiday-shortened week, as US economic data were predominantly positive and investors seemed more accepting of a rate hike in December. However, Chinese stocks fell on Friday, as investors grew nervous over officials’ efforts to regulate brokers. The Chicago Board Options Exchange Volatility Index (VIX) traded near a calm 15, down from 20 in recent weeks. This week’s reports:
- US GDP grew at an upwardly revised 2.1% annual pace in the third quarter, according to the US Department of Commerce but still down from a 3.9% growth rate in the second quarter. The latest reading was revised higher largely because inventories grew more than first estimated
- Consumer spending, a bright spot, increasing at a 3% rate.
- Personal income rose 0.4%
- The personal savings rate rose to 5.6%, its highest level in nearly three years
- The Conference Board’s consumer confidence index fell in November to the lowest level in more than a year, dropping to 90.4 from 99.1 in October
- The future expectations index dropped to 78.6 from 88.7, a two-year low, as the job market was viewed less positively
- Orders for US durable goods rose 3% in October after a decrease of 0.8% in September
- The sale of new US single-family homes increased in October by 10.7% to a seasonally adjusted annual rate of 495,000
- However, existing-home sales fell by 3.4% to an annual rate of 5.36 million units
- The S&P/Case Shiller composite index of home prices in 20 US cities increased 5.5% from a year earlier in September, up from a 5.1% year-over-year rise in August. The report represents an increase in residential real estate and supports a US Federal Reserve rate hike in December
- Initial jobless claims fell 12,000 to 260,000 for the week ending November 21st. Initial claims have now been below the 300,000 threshold for 38 straight weeks and are close to 40-year lows
- Continuing claims increased 34,000 to 2.21 million for the week ending November 14th
For the week, the S&P 500 rose by 0.05% for a year to date return of 1.52%.
IBD: Confirmed uptrend
GMI: 6/6- Buy signal since market close of October 19, 2015
BCI: Same stance as last week: Cautiously bullish using an equal number of in-the-money and out-of-the-money strikes. I remain fully invested using 50% in-the-money strikes until the Fed makes its position on interest rates known and evaluating the ensuing market reaction. I believe that most institutional investors have factored in a 25 basis point rate hike with moderating guidance from the December Fed meeting.