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Conversion / Reversal Arbitrage: Summary
Conversion / Reversal Arbitrage - Definition
Conversion & Reversal Arbitrage is an options arbitrage strategy which takes advantage of discrepancies in the value of synthetic positions and their represented equal in order to return a risk-free profit.
Conversion / Reversal Arbitrage - Introduction
You need a comprehensive knowledge of options arbitrage as well as synthetic positions before you can fully understand Conversion & Reversal Arbitrage.
Conversion & Reversal Arbitrage takes advantage of dramatic breaches in Put Call Parity resulting in significant differences in the value of a synthetic position and the actual position that it represents. For example, when the value of a synthetic long stock is significantly different from the underlying stock itself, a Conversion / Reversal Arbitrage opportunity exists. Such opportunities are extremely rare in options trading, gets filled out and corrected quickly and may not result in enough profits to justify the commissions paid. That is why Conversion & Reversal Arbitrage remains the domain of professional options traders such as floor traders and market makers who need not pay broker commissions.
What Is Conversion & Reversal?
Synthetic positioning allows an open options trading position to be synthetically closed without selling the position itself. For example, a synthetic long stock can be synthetically closed by shorting a corresponding amount of the actual stock. Synthetically closed positions are no longer be subject to directional risk and serves to hedge against short term price swings.
Very simply, a Conversion is when stock is being bought in order to synthetically close out a synthetic short stock position and a Reversal is when stock is being shorted in order to synthetically close out a synthetic long stock position. However, Conversion & Reversal do not necessarily apply only to synthetic long and short stocks.
In fact, whenever a synthetically closed position involves a long stock, it is known as a Conversion and whenever it involves a short stock, it is known as a Reversal. For example, a synthetic call option consisting of a long put and a long stock can be synthetically closed by shorting a call option. This is referred to as a Conversion as the whole position involves a long stock. A synthetic put option consisting of a long call and short stock can be synthetically closed by shorting a put option. This is referred to as a Reversal as the position involves a short stock.
When a position is synthetically closed using Conversion & Reversal, it is subjected only to theta risk, which is time decay on the extrinsic value of the long options involved in the position.
What Is Conversion & Reversal Arbitrage?
When put call parity is in force perfectly, the total amount of extrinsic value in the synthetic position should be exactly the same as the amount of extrinsic value in the actual instrument. For instance, a synthetic long stock should have no extrinsic value at all as the premium of the put option cancel out the premium of the call option involved. A synthetic long call should have the same amount of extrinsic value as the actual call option itself. However, there are conditions when Put Call Parity is so severely violated that a significant difference in extrinsic value exist between a synthetic position and its actual instrument. When such a position is synthetically closed out, a profit results from that difference in extrinsic value upon expiration when a Conversion or Reversal is used. This is known as Conversion / Reversal Arbitrage.
Floor traders and Market makers use conversions when options are relatively overpriced and use reversals when options are relatively underpriced. Most floor traders and market makers use conversion & reversal arbitrage only between stocks and its synthetic long or short stock positions eventhough it can extend to any kind of synthetic positions. Conversion & Reversal arbitrage can also be conducted between options and futures instead of the underlying stock. This makes Conversion & Reversal arbitrage an extremely complex and wide field in options arbitrage.
In reality, there will always be a difference in extrinsic value between a synthetic position and its actual instrument but that difference is usually so small that it hardly justifies the commissions paid on the position as well as the bid/ask spread loss involved in every leg.
When To Use Conversion & Reversal Arbitrage?
When a significant difference in total extrinsic value exists between a financial instrument and its synthetic equal. We will focus this tutorial on just 4 examples; Synthetic Short Stock Conversion Arbitrage, Synthetic Long Stock Reversal Arbitrage, Synthetic Long Call Conversion Arbitrage and Synthetic Short Call Reversal Arbitrage.
How To Establish Conversion & Reversal Arbitrage?
Simply conduct Conversion or Reversal to synthetically close out the original position.
Profit Potential Of Conversion & Reversal Arbitrage
A properly executed Conversion & Reversal Arbitrage has zero chance of a loss no matter how the underlying stock moves.
Profit Calculation of Conversion & Reversal Arbitrage :
Maximum Profit = Net credit resulting from the execution
(During expiration of the options involved)
Risk / Reward of Protective Puts:
Maximum Profit: Limited
Maximum Loss: No Loss Possible
Advantages of Conversion & Reversal Arbitrage
:: Able to obtain risk-free profits.
Disadvantages of Conversion & Reversal Arbitrage
:: Conversion & Reversal Arbitrage opportunities are extremely hard to spot as price discrepancies are filled very quickly.
:: High broker commissions makes Conversion & Reversal Arbitrage difficult or plain impossible for amateur trader.
:: Resulting credit spread position means that traders with low trading level may not be able to put on such a position.