V. 22:6 (64-66): Put/Call Parity by Alex Mendoza
Hereís a look at the basic relationships between calls and puts with identical strikes and expiration dates.
According to the most common option pricing models, volatility is equal for calls and puts with the same strike and expiration. This rule originates from the construction of the Black-Scholes model. Quite simply, since a call and its corresponding put expire at the same time, time value in one should be equal to time value in the other. Given that all of the other components of the option prices are known and equal, it follows that a relationship must exist between the value of a call and that of its corresponding put. While the various option pricing models use partial differential equations to obtain these values, there is a simpler way to establish put/call relationships.
Iíll begin by examining the graphical relationship between puts and calls. Take a look at the option chain in Microsoft (MSFT), focusing on the April 2004 options.