34 lines
2.3 KiB
Plaintext
34 lines
2.3 KiB
Plaintext
The stock component of the married put could be purchased on margin.
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Buying stock on margin is borrowing capital to finance a stock purchase.
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This means the trader has to pay interest on these borrowed funds. Even if
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the stock is purchased without borrowing, there is opportunity cost
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associated with the cash used to pay for the stock. The capital is tied up. If
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the trader wants to use funds to buy another asset, he will have to borrow
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money, which will incur an interest obligation. Furthermore, if the trader
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doesn’t invest capital in the stock, the capital will rest in an interest-bearing
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account. The trader forgoes that interest when he buys a stock. However the
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trader finances the purchase, there is an interest cost associated with the
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transaction.
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Both of these positions, the long call and the married put, give a trader
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exposure to stock price advances above the strike price. The important
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difference between the two trades is the value of the stock below the strike
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price—the part of the trade that is not at risk in either the long call or the
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married put. On this portion of the invested capital, the trader pays interest
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with the married put (whether actually or in the form of opportunity cost).
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This interest component is a pricing consideration that adds cost to the
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married put and not the long call.
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So if the married put is a more expensive endeavor than the long call
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because of the interest paid on the investment portion that is below the
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strike, why would anyone buy a married put? Wouldn’t traders instead buy
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the less expensive—less capital intensive—long call? Given the additional
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interest expense, they would rather buy the call. This relates to the concept
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of arbitrage. Given two effectively identical choices, rational traders will
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choose to buy the less expensive alternative. The market as a whole would
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buy the calls, creating demand which would cause upward price pressure on
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the call. The price of the call would rise until its interest advantage over the
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married put was gone. In a robust market with many savvy traders,
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arbitrage opportunities don’t exist for very long.
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It is possible to mathematically state the equilibrium point toward which
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the market forces the prices of call and put options by use of the put-call
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parity. As shown in Chapter 2, the put-call parity states
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