Put/Call Parity

Execution * Research

141 W. Jackson Blvd. 1220A Chicago, IL 60604 Consulting * Asset Management

The grain markets had an extremely volatile day today, and with the wheat market locked limit, many traders and customers have questions on how to figure out the futures price of the underlying commodities via the options market - Or the synthetic value of the futures. Below is an educational piece that should help brokers, traders, and customers find that synthetic value using the options markets.

Any questions please do not hesitate to call us.

Best Regards, Linn Group Management

PUT/CALL PARITY

Despite what sometimes seems like utter chaos and mayhem, options markets are in fact, orderly and uniform. There are some basic and easy to understand concepts that are essential to understanding the marketplace.

The first and most important option concept is called put/call parity . This is simply the relationship between the underlying contract and the same strike, put and call. The formula is: Call price – put price + strike price = future price*

Therefore, if one knows any two of the inputs, the third can be calculated. This triangular relationship is the cornerstone of understanding how options work and is true across the whole range of out of the money and in the money strikes.

* To simplify the formula we have assumed no dividends, no early exercise, interest rate factors or liquidity issues.

By then using this concept of put/call parity one can take the next step and create synthetic positions using options. For example, one could buy a put and sell a call with the same exercise price and expiration date which would be the synthetic equivalent of a short future position.

www.LinnGroup.com 312.896.2001

Reproduction or rebroadcast of any portion of this information is strictly prohibited without the written permission of the Linn group, inc. the information reflected herein is derived from sources believed to be reliable; however, this information is not guaranteed as to its accuracy or completeness. Opinions expressed are subject to change without notice. this material and any view expressed herein are provided for informational purposes only and should not be construed in any way as an inducement to buy or sell commodity futures or options contracts. The Linn group and its officers, directors, employees and affiliates may take positions for their own accounts in contracts referred to herein. Trading futures involves risk of loss Execution * Research

141 W. Jackson Blvd. 1220A Chicago, IL 60604 Consulting * Asset Management

SYNTHETIC POSITIONS

For options that have the same exercise price and expiration date.

Synthetic equivalents: Long futures = long call + short put Short futures = short call + long put Long call = long futures + long put Short call = short futures + short put Long put = short futures + long call Short put = long futures + short call Conversion = long futures + short call + long put Reversal = short future + long call + short put

These synthetic positions can be executed in an option market at any time but become extremely important during days like today when the wheat futures market was locked limit and the options market provided a means for eliminating ** market exposure.

** A synthetic position is only an equivalent -- not an offsetting position and does create pin risk, which is the option trader's expiration risk when short an ATM option. Since only the owner (buyer) of an option can exercise their right to be long or short an underlying position the short is at their mercy. So, when the underlying market settles at or near a strike (the owner has a right to exercise any option) the short will not know until the next trading session whether they have a position in the underlying market. This can be avoided by simply buying in the short option as expiration approaches at whatever the prevailing market price.

Below is a worksheet in which one can test their knowledge of put/call parity and the concept of synthetic equivalents.

CORN WHEAT BEANS MARCH MARCH MARCH PX = ? PX = 344 PX =694 ½ STRIKE CALLS PUTS STRIKE CALLS PUTS STRIKE CALLS PUTS 220 26 ¾ 5 310 ? 3 ¼ 640 62 ¼ ? 230 20 ½ 8 ¾ 320 ? 5 ¾ 660 47 ½ ? 240 15 ½ 13 ¾ 330 ? 9 ¼ 680 36 ? 250 12 20 ¼ 340 ? 13 ¾ 700 26 ? 260 9 27 ¼ 350 ? 19 ¼ 720 19 ½ ? 270 7 35 ¼ 360 ? 26 740 14 ½ ? 280 5 1/4 43 ½ 370 ? 33 ½ 760 11 ½ ?

www.LinnGroup.com 312.896.2001

141 W. Jackson Blvd. 1220A Chicago, IL 60604 Consulting * Asset Management

Answers below:

CORN WHEAT BEANS MARCH MARCH MARCH PX = 241 ¾ PX = 344 PX =694 ½ STRIKE CALLS PUTS STRIKE CALLS PUTS STRIKE CALLS PUTS 220 26 ¾ 5 310 37 ¼ 3 ¼ 640 62 ¼ 7 ¾ 230 20 ½ 8 ¾ 320 29 ¾ 5 ¾ 660 47 ½ 13 240 15 ½ 13 ¾ 330 23 ¼ 9 ¼ 680 36 21 ½ 250 12 20 ¼ 340 17 ¾ 13 ¾ 700 26 31 ½ 260 9 27 ¼ 350 13 ¼ 19 ¼ 720 19 ½ 45 270 7 35 ¼ 360 10 26 740 14 ½ 60 280 5 1/4 43 ½ 370 7 ½ 33 ½ 760 11 ½ 77