Married Put vs. Long Call – Revisited

In this article, we’ll forever (yeah, right!) put away the argument that buying stock and buying a protective put option is somehow the SAME THING as buying a call option.

Sigh… It looks like once again I have to address this question of long calls versus married puts.

Seems that there are a few self-appointed critics out there that still fail to recognize the math behind parity, and therefore make the mistake of claiming that a married put trade and a long call trade are identical.

I’ve read a lot of blog posts about RadioActive Trading, some flattering and some less flattering… and I have to admit I’m very, VERY happy about the controversy… because even the negative stuff gets the word out more. No news is bad news, as they say.

Before even going into the argument about why I use married puts, and why they are not the same thing as call options, let’s examine this word, “IDENTICAL”. Identical means that there is NO difference at all between one thing and another.

First, I’ll say that not even “identical” twins are truly identical. Their personalities have differences, they have different fingerprints, and I’ve known several pairs of them. I can tell the difference. Even if I couldn’t tell the difference, THEY would be able to, wouldn’t they? You would never hear, for example, an argument between identical twins like this:

“I’m Tommy.”
“No, I’M Tommy, you’re Timmy!”

😉

Kidding aside, it never ceases to boggle my mind how my critics will say that long calls are IDENTICAL to married puts, and then go on to say that long calls are better because they require less capital.

Identical but better? Hmm? What’s that word mean again?

If we want to stick with the word, “identical” we’d at least better be consistent. If we say that two things are identical but one is better, that is an oxymoron. Reminds me of civil rights questions… you know, all men are created equal… but! SOME are created more “equal” than others. Doesn’t fly very well, does it? Not in real life.

Well, I promised a math lesson, not a language lesson… but one quality that those two disciplines share is logic. That’s why it doesn’t surprise me that folks that don’t pay much attention to math can’t seem to express themselves adequately with language either.

So let’s tackle the logic, now that we’ve handled the inescapable fact that the two trades are NOT (as defined by my critics’ own comments) the same in every way.

Okay, are we ready? First off, we have to do away with the word, “IDENTICAL” and instead begin to use the word, “PARITY”.

Here’s the financial definition for the word, parity, available at
http://financial-dictionary.thefreedictionary.com/parity :

1. The state of being equal… parity is achieved when the value of a convertible security equals the value of the underlying common stock.

What’s a convertible security? Why, it’s any combination of the following: cash, bonds, stock, options, et cetera… that can be exchanged for another convertible security.

For example, a call option on a certain security that’s in the money, plus a certain amount of CASH… may be exchanged for the underlying stock plus a put at the same strike. There is parity in this trade, because things equal to the same thing are equal to each other.

Let’s make a little comparison between a married put trade and a long call trade:

June 1st, 2006: March 07 $115 options. DIA trading at $112.40

Calls Puts

Bid $5.40 Ask $5.70 Bid $5.70 Ask $5.90

To buy the March 07 $115 calls, you would spend only $5.70.
OTOH, to buy a married put trade at the same strike, you would spend $112.40 + $5.90 = $118.30.

Let’s compare: at first blush, it seems that DIA calls would be a better way to go, because… well, that’s so much cheaper! After all, we only have to commit $5.70 with the long calls, and $118.30 with the married put.

But these are supposed to be PARITY plays, meaning that they bear the exact same risk and reward as a dollar amount. Right? Okay, let’s see how that works out. Fast forward to St. Patty’s day… on March 17th, DIA is now at $121.05. Both plays made a profit.

First, the long call: How much is it in the money? $121.05 – $115 = $6.05.

So we may either spend $115 plus turn in our call in exchange for 100 shares of DIA… or we may simply sell the call and count our profits. Let’s do that:

$6.05 (value of the call at expiration) – $5.70 (what we spent for said call) = $.35.

We’ve made a $.35 profit on our investment of $5.70, or 6.14%. Good deal.

Now let’s count up the married put trade: The put is worthless, and DIA is trading at $121.05. Let’s subtract that current price from the amount that we spent for the married put: $121.05 – $118.30 = $2.75

Now, tell me I’m missing something… the long call made only $.35, whereas the married put made $2.75, not to mention the dividends (DIA pays them monthly) that you would have collected for owning the stock. You would not have collected them if you’d only been holding a call option.

Hmmm. That’s a different dollar amount, isn’t it?
(here’s where you nod, YES)
..but my critics, the ones that say that buying a call at the $115 strike price is IDENTICAL to buying the stock and a put at the same strike…. will continue to maintain that they are somehow the same exact play. Of course, by now they have abandoned the word, “identical” because long calls are (supposedly) BETTER… 😉

Well, here’s the part where we find out whether they were right…or NOT… to say that these were even “parity” trades to begin with.

Here’s the deal. It’s what I keep TRYING to say, and what my critics keep sweeping under the carpet:

A long call at the $115 strike is NOT on parity with buying the stock plus a put at the same strike. It just isn’t. If that were so, the dollar amounts of profit would be exactly the same… but they aren’t.

The married put cost a total of $118.30 to put on, yes. And as a percent, it returned less but the dollar amount is much more. What WOULD make this a parity, a synthetic equivalent, an exact dollar for dollar and trade would be this tiny tweak:

AT the MOMENT that you buy the long, $115 call for $5.70… take the remaining ($118.30 – $5.70) = $112.60 and put it in an interest bearing account.

You will find that the meager profit for the long call of only $.35… will be supplemented by the interest from that deposit.

In fact, you’ll find that the interest from depositing that much capital (and not touching it) plus the $.35 profit from the long call trade will be PRETTY MUCH THE SAME as investing $118.30 in the stock plus put…. and having $2.75 in profits plus dividends.

Some folks may wish to keep repeating the mantra (as though that will make it true): calls are same as married puts… calls are same as married puts… calls are same as married puts… calls are same as married puts…

…but they are mistaken.

A married put is not equal, equivalent, parity, or IDENTICAL to a long call. No way. A married put is parity with a long call WHEN (and only when) there is a commensurate amount of capital on deposit in a risk-free interest-bearing account.

Period.

I’ll say it one last time, because it bears observance: a properly purchased married put is less risky when you’re wrong, and more profitable when you’re right… than a simple long call. Just pointing out that a call costs less does not make it better.

To make a long call be truly equivalent to a married put, one must put the SAME AMOUNT OF CAPITAL into both trades. You must buy stock and a put, or you must buy T-Bills and a call. No way around it, not if you want to have the same exact risk/reward picture.

This condition of having capital on deposit in an interest bearing account WOULD make a long call “parity”, “synthetically equivalent”, or any other word you might choose (except of course, IDENTICAL) to express the similarity between these two instruments.

You have to have capital to trade effectively… and that’s the truth. Seeking to use a call ALONE as a substitute for the capital you need to make your trading account shake and bake, just won’t work.

SO next time you read a blog post written with a superior-sounding attitude that asserts “Oh, trading married puts is JUST THE SAME THING AS trading a long call… there’s NO difference… except that calls are better…”

Well, now YOU’LL know better.

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