Futures and Options – The basics.

Options: Put call parity – Part II

If we recall the strategies of two investors we mentioned in our last post, one was ‘buy a call and invest the present value of exercise price in risk free assets’ and the second  was ‘Buy shares on spot and buy a put’. Both these strategies were identical in pay-offs. The basic relationship was also drawn. Now, let’s put down that as formula:

  • S + PE  = C  + PV

Where,

  • S    = Spot buy price of a share
  • PE = Buy European put
  • C = Buy European Call
  • PV = Present value of cash invested in risk free securities.

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Options: Put-Call parity-Part I


Is there a relationship between the value of a call and the value of a put? The guy who answered that question for the very first time was Economist Hans Reiner Stoll in his book, “The Relation between Put and Call Prices” in 1969. The theory is also known as the law of one price. According to him, the prices of a call and a similar put are tied together and when one moves the other should move and vice versa.

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Options: Break-even point.

Knowledge about the concept of break even is very important in finance. In F & O’s too, identification of break even price is very crucial to take the right decisions.

WHAT IS BREAK EVEN?

Break even point is that point at which you make no profit or no loss. It is the minimum rate of return that your investment should generate in order to maintain a no profit-no loss situation. However, No profit /Loss is not the point where your purchase price matches with the sale price. Your break-even point must include the recoupment of all fees, commissions and other expenses associated with the purchase and sale of the investment.

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Options: Choices of action.

CHOICES OF ACTION – for the holder and writer.

After a person has bought an option, what are the choices of action he has? That’s the next topic we need to discuss.

In the case of the holder of a call, He has 3 choices before him –

  • Do nothing – wait till the expiry
  • Close out – reverse his trade. I.e. if he bought a call, write a matching call.
  • Exercise the option – ( in the case of American options only )

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