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Finance and capital markets
Course: Finance and capital markets > Unit 9
Lesson 1: Put and call options- American call options
- Basic shorting
- American put options
- Call option as leverage
- Put vs. short and leverage
- Call payoff diagram
- Put payoff diagram
- Put as insurance
- Put-call parity
- Long straddle
- Put writer payoff diagrams
- Call writer payoff diagram
- Arbitrage basics
- Put-call parity arbitrage I
- Put-call parity arbitrage II
- Put-call parity clarification
- Actual option quotes
- Option expiration and price
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Put-call parity clarification
The put-call parity formula for American options is considerably more complicated than for European options. In this video we explore what the difference in how these options can be exercise complicates this concept. Created by Sal Khan.
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I don't see why this would only be possible for European trading. In the case of American trading, if the options are exercised before the expiration date, it's true you might have to dip into your funds to pay the buyer of the option, but wouldn't that money be made back when the bond comes due, so that the NET effect is still the same? Or if the stock fluctuates, maybe both parties exercise their options and so both of them make money, instead of one being worthless, since if the market isn't going your way, you'd hold until the last possible minute anyway. Right?(7 votes)
Don't forget about dividends. If you hold this position til expiration to flatten out and there is a dividend and your holding short stock you will be paying out the dividend from your account. If your short a call and it gets excercised before expiration (only happens with American options) then you could also end up with short stock and a dividend liability. A few other things: You are putting on a four legged trade and you will definetely have price fluctuations while working this on the open market. Rarely does this add up. The price difference between each half of this equation usually is a few pennies and you need enormous equity to trade it if you want to have enough size to make it worthwile. If you do see a large anomaly in parity then look out and due some due dilligence. There might be a special dividend about to be announced. Good luck making money this way.(7 votes)
The names European and American options - is that just a name or are the respectively named options ONLY practiced/traded in America/Europe?(4 votes)
It's only in the name and has nothing to do with where the options are traded.(7 votes)
When these arbitrage scenarios are exploited, which then as I under stand should balance and eliminate them, what does that mean for the actual balance of the market?
I understood this type of balance in the apples example but I don't see what is happening conceptually here(2 votes)
As the arbitrage starts getting exploited over a period of time - the stock we short would start going down and the put option we write would also start becoming cheaper (supply increases --> price decreases). Also as we start buying more bonds and call options they would start getting more and more expensive (demand increases --> price increases). I think there would be some oscillations before the parity would ultimately set in.(5 votes)
If the only profit one is going to get is the bond interest made, then why not just do the bond instead of doing the short, writing the put, and buying the option?(2 votes)
You can. The point is not that you should do one or the other. The point is just that they are equivalent, so the prices have to reflect that.(3 votes)
- I am doing put call parity for a deriviatives exam and it being taught with the equation +C -P =S -K (long call - put = Spot - Strike), can you relate this to what you are teaching?
Also, I'm getting a bit confused around the difference between Spreads and Basis trading, and completely lost when talking about reversals and conversions. Is there any chance you could do something on this?(2 votes)- where have you found that (long call - put = Spot - Strike)? which text book?(1 vote)
Hello, regarding the Risk Free Bond, you mean a USTreas or has to be a Bond issued by the same company of the Stock? great videos, thks so much(1 vote)
When we say a risk-free bond, we normally mean a US Treasury.(2 votes)
- I think the concept of naked calls/puts should be explained a bit more in the previous chapters, maybe at the start just to differentiate earlier the role/responsibilities of the writer vs the holder. Other than that everything is quite clearly explained so far :)(1 vote)
- Hi,
In some way how can I profit from difference in interet rate using options? For exemple, in brazil interest rate are 10%p.a, there I can buy and sell option. In the Uk interet rate i 0.5%, here I can buy and shell forward and spot cfd of the same shares. What would have happen if you opened a syntethic long (option) in brazil and short the cfd forward?(1 vote) 
In the arbitrage situation, you're always buying the items on one side of the equation and selling the ones on the other side, right? So if the holder of the option you wrote decides to exercise it, then you can always choose to do so with the option you're holding and still break even once the bond matures, right?(1 vote)- Let's assume this is American options (since could exercise before expiration like your example) that consist of Long stock, Put long and Call short, Zero bond loan. If the holder of our call exercise it, that means the underlying price is higher than the strike of call or price moving upward. Then, we as the one holding the put don't need to exercise it since the price is not favorable for us. The think we need to do is directly settle our stock position to close the exposure that later could arise from stock price correction (to avoid price moving downward after the holder exercise call), if this condition occurs then we make a loss from the different between the short call and our stock long.
So to achieve break even like you said, it's not the matter the holder options and our long options, but rather the holder options and our stock, which both should be close at the same time.(1 vote)
Video transcript
Voiceover: We've seen that the
payoff diagram at option expiration for owning the stock
plus a put on that stock at some strike price
that this payoff diagram will look exactly the
same as the payoff diagram as owning a call option on that
stock at the same strike price as the put option plus a
bond that's going to be worth the strike price at
the time of expiration. One point of clarification and actually let me just
draw that payoff diagram just so you know what it looks like. So, if this is the underlying
stock price, stock price. And let's just do the payoff diagram when we look at the value of
the portfolio or your holdings. What it looks like is this is
the strike price over here. If the stock is at the stock
price or anything lower you make a fixed value and anything above that you
get some type of upside. So, either if you have
the stock or the put you have this type of a payoff or if you have the call plus the bond. The one point of
clarification I want to make is that you can only say that this
is definitely true for European. For European call options, for European options I
should say in general. European call and put options. Because only in European options
can you know for certain, for sure that the options are
going to be exercised on the ex or they can only be exercised
on the expiration date. If we're dealing with American options either party could either on
the put side or the call side could exercise their options earlier
so it becomes a lot more complicated. Normally when we kind of deal
with the mathematics of options we're dealing with European options. So, even in the example where we
did our put-call parity arbitrage where we're able to make that free $5, the implicit assumption I made is that
we were dealing with European options. That the options could only be
exercised at the expiration date.