Thursday, February 17, 2011

Deviations from put call parity have predictive power.

We've been talking about options in class this week and we've covered put call parity.  Put call parity simply states that the call price + the present value of the strike = stock price + put price.  A question that comes up in class is what do deviations from PCP really mean?

A forthcoming article in the JFQA (a top finance journal) finds that deviations from PCP have predictive power.  When calls are relatively expensive compared to puts, the underlying stock outperforms.  Likewise, when puts are relatively expensive compared to calls the underlying stock underperforms.  These results hold the strongest for illiquid stocks that have liquid options.