Conversions are primarily a
Floor Trader strategy. To
capitalize on minor price
discrepancies between calls
and puts, floor traders and
other professionals will
sometimes put on a trade
known as a conversion.
Like all arbitrage
strategies, the conversion
involves buying something in
one market and
simultaneously selling it in
another to capitalize on
whatever small discrepancy
exists.
Traders do conversions when
options are relatively
overpriced. To put on the
position, the trader would
buy stock on the open market
and sell the equivalent
position in the option
market. When the options are
relatively under-priced,
traders will do reverse
conversions, otherwise known
as
reversals.
Theoretically, conversions
and reversals have very
little risk because the
profit is locked in
immediately.
The idea behind a conversion
is to create what is known
as a synthetic short
position and offset it with
a long position in the same
underlying stock. The
synthetic short position is
created by selling a call
and buying a put with the
same strike price and
expiration.
synthetic short
position = short call + long
put
Combining the synthetic
short position with a long
stock position creates a
conversion:
Short call + long
put + long stock
To see how this might work,
imagine that a stock is
trading at $104. At the same
time, the options are priced
as follows:
Option |
Bid |
Ask |
August 100 call |
7.60 |
7.75 |
August 100 put |
3.35 |
3.50 |
In the absence of any price
discrepancies, the following
will be true:
Call price - put
price = stock price - strike
price
In other words, if the stock
is trading for $104, the 100
calls - the 100 puts should
equal $4. At the prices
above, this calls and puts
are relatively overpriced
because the synthetic short
position (short call and
long put) can be done at
4.10.
Thus, by buying the stock
for $104, selling the call
for 7.60 (the bid) and
buying the put for 3.50 (the
offer), the trader will lock
in an .1 point profit.
Individual investors and
most other off-the-floor
traders don't have an
opportunity to do
conversions and reversals
because price discrepancies
typically only exist for a
matter of moments.
Professional option traders,
on the other hand, are
constantly on the lookout
for these opportunities. As
a result, the market quickly
returns to equilibrium. |