Put - Call Parity

• Put option value can be computed using put-call parity

• The value of Protective Put (Long Stock and Long Put) is equal to a
Fiduciary Call (long call, plus an investment in a zero-coupon bond with a
face value equal to the strike price)
• Stock + Put = Call + PV(ZCB)

• S0 + P0 = C0 + PV(X)
 Put - Call Parity: Assumptions

• Derives relationship only for European options

• Call and Put have same strike price – X

• All the instruments have the same time to maturity – T

• Stock pays no dividend

 Put - Call Parity
• Consider Two scenarios – where ST is greater than X and where ST is
less than X [S0 + P0 = C0 + PV(X)]

ST > X ST < X
Equation Portfolio Payoff Payoff
LHS Stock S S
Put 0 X-S
Total S X
RHS Zero-coupon Bond X X
Call S-X 0
Total S X
 Option Valuation – Black Scholes Merton (BSM) method
• BSM model values options in continuous time, but is based on the No-Arbitrage condition
we used in valuing options in discrete time with a Binomial Model

Key assumptions
• Risk-neutral return on combination of long stock and short call
• Instantaneous returns follow Stochastic process
• Prices follow log normal distribution
• Expected return and standard deviation are constant over the tenor
• No dividends, no transaction costs, no taxes, no arbitrage
• Trading is continuous
• Risk free interest rate is constant over the tenor
• The options are European options
 Formula for valuing European Option using BSM
• C0 = S0 N(d1) – PV(X) N(d2)

• P0 = PV(X) N(-d2) – S0 N(-d1)

where:
• d1 = [LN(S/X) + (r + 0.5 σ2) T] / σ
• d 2 = d1 – σ
• PV (X) = e-rT (X)
• T = time to option expiration
• r = continuous compounded risk-free rate
• S0 = current asset price
• X = exercise or strike price
• σ = annual volatility of asset returns
• N(d1) = normal distribution of d1
• Alternatively, Find P0 using Put Call Parity: S0 + P0 = C0 + PV(X)
• N(d1) = Probability of realizing expected value of market price / Delta of an Option
• N(d2) = Probability that call option will get exercised
 Valuing options using BSM for stocks with dividend

• If there is dividend

• Either assumed continuously at the rate q% p.a., the formula needs to modify the risk
free rate r to (r-q) to reflect the dividend
• Or one time dividend  reduce the initial price (S0) by the PV of dividend / stream of
dividends till expiry

• If no dividend is expected prior to the expiry, the calculation is same as that for a non-
dividend paying stock

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 Valuing options using BSM

• Option calculators are readily available on the web using this model to calculate
option price or “implied volatility” given the actual option premium

• https://www.cboe.com/education/tools/options-calculator/

• https://zerodha.com/tools/black-scholes/

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Option Calculator

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Option Chain

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 Option Chain
• Options get traded for several “strikes” for the same underlying

• Mispricing across strikes gets adjusted through arbitrage

• Prices for call and put get adjusted as per arbitrage on put call parity

• Implied volatilities are different at different strikes

• Implied volatilities are different for call and put at the same strike

• This phenomenon is observed across various markets

• Called “volatility smile”

• Shape of the volatility vs strike curve is specific to a particular market micro-structure

• There has been ample empirical research on this 10

 Historical vs Implied Volatility (IV)
• Historical / Observed volatility pertains to the past period whereas the Implied Volatility reflects
the expectations for the future period

• Hence implied volatility contains more meaningful information

• However, its value changes for every trade

• It varies for various strikes, for put vs call and for various expiries

• It may not reflect the market sentiment if based on a thinly traded option

• Stocks which have no option contracts would not have implied volatility

• Higher IV often implies market is in the Bearish sentiment and Lower IV implies market is in the
Bullish sentiment

• Traders often act / use / compare IV of the options rather than option premiums / price

• IV can be computed using BSM model by assuming the quoted Option price to be correct
 Sensitivities of call option premium

• Call option premium changes with

• Change in the price of the underlying asset

• Change in time till expiration

• Change in interest rates

• Change in volatility (i.e. the fluctuation in the price of the underlying

asset)

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 Option Greeks

• Call option premium changes with

• Change in the price of the underlying asset (delta)

• Change in time till expiration (theta)

• Change in interest rates (rho)

• Change in volatility (i.e. the fluctuation in the price of the underlying asset)
(vega)

• Change in delta with change in underlying asset price (gamma)

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 Delta

change in change in
Expiry strike Volatility Risk free CMP Call option price call option underlying Delta
price price

30 100 18% 5% 100 2.2658

30 100 18% 5% 100.1 2.3204 0.0546 0.1 0.546

• Delta is the change in the option price per one rupee change in the price of the underlying
• Delta for Call is Positive and Delta for Put is Negative

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 Delta for Call / Put
• Delta for Call = N(d1) derived in BSM Model

• Delta for put = Delta for call at the same strike – 1 OR {N(d1) – 1}

• Delta is close to zero for out-of-the money option. Delta is close to 1 for in-the-
money options. Delta is close to 0.5 for at-the-money options

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 Gamma

• Delta changes at every price level of the underlying.

• Change in Delta for one rupee change in the price of the underlying is called
Gamma.

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 Vega

• Change in option price for 1% change in volatility

Volatility call option price

18% 2.266

19% 2.380

Vega 0.114

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 Theta

• Change in option price per day as the number of days to expiry reduce

• It is also knows as “Time Decay”

change
Risk Call option in call # of days
Expiry strike Volatility CMP Theta
free price option change
price
30 100 18% 5% 100 2.266
0.042 1 0.042
29 100 18% 5% 100 2.224

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 Dynamic hedging / trading and arbitrage using
options (Illustrative)

• Option traders actively use dynamic hedging strategies

• Such strategies use combination of call, put options and futures

• Usually, these strategies remain market neutral

• Mix of various instruments is changed periodically as the market moves so

that the portfolio remains neutral to the market
• The trading is based on “Greeks” such as Delta, Vega and Gamma

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 Delta Hedging (Illustrative)
• Combination of long position in 5583 Nifty units and short position in 10000
units of Nifty call would not change in value for small changes in the price of
Nifty

• Delta of 0.5583 means that Re 1 change in stock price would lead to Re

0.5583 change in the price of the option

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 Using delta hedging for trading (Illustrative)
• Create short position in call when option price is either

• Higher than expected (expectation can be based on BSM model), or,

• high due to higher than normal volatility

• Hedge the short call position by buying stock using delta

• Adjust the stock holding periodically (i.e. dynamically) as the stock price moves up or
down; using the revised delta at each price level

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