Straddle (sort of) question

[commiebat]

Quote from riskfreetrading:

The put-call parity comes with many ifs:

1. both positions are assumed to be held until expiration.
[...]
3. Valid only for european style options. Excercise risk can invalidate 1.
4. There are other risks, liquidity, interest rate risk, etc.
5. They may not be equivalent with regard to the greeks if exercise is american style.

Looks like you've got some problems there.

Your points 1, 3 and 5 are the same thing. And they're still wrong. Put-call parity applies to American options as much as to European. Sure, interest rate is a risk - albeit a negligible one, and you can break parity if the stock becomes unavailable to short or something (is that what you meant by "liquidity"?), but parity holds in your garden variety American option position.

I wouldn't worry too much about early assignment, since if your short gets that DITM you're pretty much boned anyway, and you'd still have parity because the long option in the equivalent position would have no bid.

 

[riskfreetrading]

Quote from commiebat:

Looks like you've got some problems there.

Your points 1, 3 and 5 are the same thing. And they're still wrong. Put-call parity applies to American options as much as to European. Sure, interest rate is a risk - albeit a negligible one, and you can break parity if the stock becomes unavailable to short or something (is that what you meant by "liquidity"?), but parity holds in your garden variety American option position.

I wouldn't worry too much about early assignment, since if your short gets that DITM you're pretty much boned anyway, and you'd still have parity because the long option in the equivalent position would have no bid.

I am not sure what you meant and understood from my comments. The essence of what I wanted to say is that when exercise is american style, and other things, the american option put (or call depending on carry) carries an additional premium. Therefore if american style, put-call parity cannot hold in the european exercise sense as the excercise can happen earlier than on expiration date. European option can go below instrinsic value, american cannot.

 

[riskfreetrading]

Quote from nravo:

Isn't my risk greater with a short put, as I have volatility risk. A put could, while falling downward, spike higher than falling future, no?

If you look at the BS (no negative things intended) model the vega convexity is not priced.

 

[nravo]

Quote from riskfreetrading:

I am not sure what you meant and understood from my comments. The essence of what I wanted to say is that when exercise is american style, and other things, the american option put (or call depending on carry) carries an additional premium. Therefore if american style, put-call parity cannot hold in the european exercise sense as the excercise can happen earlier than on expiration date. European option can go below instrinsic value, american cannot.

Just curious: How can an option go below intrinsic value? Doesn't that create an arbitrage opportunity?

 

[commiebat]

Quote from nravo:

Just curious: How can an option go below intrinsic value? Doesn't that create an arbitrage opportunity?

Not if the option can't be exercised to capture the intrinsic value.

 

[atticus]

Quote from commiebat:

Not if the option can't be exercised to capture the intrinsic value.

Calc the risk-free rate to expiration and add the value to the share price. The discount on a European put may arise if the cost to finance the strike exceeds the premium on the same-strike call.

Sell a put over a CC if you believe rates will rise or the divie will fall. Trade the CC over the put of you think rates will fall or the divie will rise. This is applicable to any risk-position or arbitrage and is the foundation of leveraged rate-trading in the option markets.

 

[riskfreetrading]

Quote from atticus:

Calc the risk-free rate to expiration and add the value to the share price. The discount on a European put may arise if the cost to finance the strike exceeds the premium on the same-strike call.

Sell a put over a CC if you believe rates will rise or the divie will fall. Trade the CC over the put of you think rates will fall or the divie will rise. This is applicable to any risk-position or arbitrage and is the foundation of leveraged rate-trading in the option markets.

Excellent explanation! Would also like to add that if one is long a call one is implicitely holding a borrowing position. The opposite for a long put (lending position). So interest rise after transaction has positive impact on long call and short put holders. This may be helpful in remembering impact of interest rate, but does not add anything to the conclusion of Atticus.