Lawrence D. Cavanagh

Are Puts Cheaper Than Calls?

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This article originally appeared on The Options Insider Web site.

In this article, we'll be reviewing what are known as the put-call parity rules. If you know one rule -- and you remember your high school algebra -- you can quickly master all the rules. Mastery of these rules gives you a lot more flexibility when planning your option strategies.

Look at most option prices in which the stock price is close to the strike price. You are likely to see that put premiums are lower than call premiums. So, are puts cheaper than calls?

In fact, the time premiums of puts and calls at the same strike price (and the same expiration) are theoretically (and for practical purposes) the same. Why, then, do call premiums usually appear to be higher?

The answer is that with the stock equal to the strike, the calls are often in-the-money and the puts are out-of-the-money. This is because the real price of the underlying is the stock's future delivery price, which is determined by the stock's dividend and the going interest rate, as well as by the stock price.

If the interest rate is higher than the dividend rate (as it usually is), then the stock's future delivery price will be higher than its current price.

Breaking It Down

If you are a market maker and you need to buy the stock (and lock in a price) for one-year delivery (for a call you are writing), you need to borrow the funds (at the one-year interest rate) to buy the stock.

This increases your effective price of the stock. However, you also get to collect the dividends (if any) on the stock. This will reduce your price.

Thus, if the current stock price is $100, the one-year interest rate is 6% and the dividend rate is 1% p.a., then the real cost of the stock for a one-year option is $105.

Most simply, the price for future delivery of the stock is: Stock Price + Interest - Dividend.