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Conversion & Reversal Arbitrage
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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.
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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.
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Synthetic Position
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Components
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Closing Instrument
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Classification
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Synthetic Long Stock
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Long Call + Short Put
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Short Stock
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Reversal
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Synthetic Short Stock
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Short Call + Long Put
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Long Stock
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Conversion
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Synthetic Long Call
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Long Stock + Long Put
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Short Call
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Conversion
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Synthetic Short Call
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Short Stock + Short Put
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Long Call
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Reversal
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Synthetic Long Put
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Short Stock + Long Call
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Short Put
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Reversal
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Synthetic Short Put
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Short Call + Long Stock
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Short Put
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Conversion
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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.
Synthetic Short Stock Conversion Arbitrage Example :
Assuming ABC company's shares are trading at $51 and its March $51 Call is trading at $2.50 and its March $51 Put is trading at $1.50.
Extrinsic Value Of Synthetic Short Stock = $1.50 - $2.50 = $1.00 credit
Extrinsic Value Of Short Stock = $0
There is a $1.00 difference in extrinsic value between the Synthetic Short Stock and the actual Short Stock, therefore,
Conversion Arbitrage is possible.
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Synthetic Long Stock Reversal Arbitrage Example :
Assuming XYZ company's shares are trading at $51 and its March $51 Call is trading at $1.50 and its March $51 Put is trading at $2.50.
Extrinsic Value Of Synthetic Long Stock = $1.50 - $2.50 = $1.00 credit
Extrinsic Value Of long Stock = $0
There is a $1.00 difference in extrinsic value between the Synthetic Long Stock and the actual Stock, therefore,
Reversal Arbitrage is also possible.
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Synthetic Long Call Conversion Arbitrage Example :
Assuming XYZ company's shares are trading at $51 and its March $51 Call is trading at $2.50 and its March $51 Put is trading at $1.50.
Extrinsic Value Of Synthetic Long Call = $0 + $1.50 = $1.50
Extrinsic Value Of long Call = $2.50
There is a $1.00 difference in extrinsic value between the Synthetic Long Call and the actual Call option, therefore,
Conversion Arbitrage is possible.
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Synthetic Short Call Reversal Arbitrage Example :
Assuming XYZ company's shares are trading at $51 and its March $51 Call is trading at $1.50 and its March $51 Put is trading at $2.50.
Extrinsic Value Of Synthetic Short Call = $0 - $2.50 = $2.50 credit
Extrinsic Value Of Short Call = $1.50
There is a $1.00 difference in extrinsic value between the Synthetic Short Call and the actual Short Call option, therefore,
Reversal Arbitrage is also possible.
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How To Establish Conversion & Reversal Arbitrage?
Simply conduct Conversion or Reversal to synthetically close out the original position.
Synthetic Short Stock Conversion Arbitrage Example :
Assuming ABC company's shares are trading at $51 and its March $51 Call is trading at $2.50 and its March $51 Put is trading at $1.50.
Extrinsic Value Of Synthetic Short Stock = $1.50 - $2.50 = $1.00 credit
Buy 100 shares of ABC stock to complete the Conversion Arbitrage. Upon expiration, you will make $100 ($1 x 100) per position risk
free.
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Synthetic Long Stock Reversal Arbitrage Example :
Assuming XYZ company's shares are trading at $51 and its March $51 Call is trading at $1.50 and its March $51 Put is trading at $2.50.
Extrinsic Value Of Synthetic Long Stock = $1.50 - $2.50 = $1.00 credit
Short 100 shares of XYZ stock to complete the Reversal Arbitrage. Upon expiration, you will make the $100 ($1 x 100) credit per position
risk free.
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Synthetic Long Call Conversion Arbitrage Example :
Assuming XYZ company's shares are trading at $51 and its March $51 Call is trading at $2.50 and its March $51 Put is trading at $1.50.
Extrinsic Value Of Synthetic Long Call = $0 + $1.50 = $1.50
Short 1 contract of March $51 Call for a credit of $250 to complete the Conversion Arbitrage.
Upon expiration, you will make the $100 credit ($250 - $150)
per position risk free.
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Synthetic Short Call Reversal Arbitrage Example :
Assuming XYZ company's shares are trading at $51 and its March $51 Call is trading at $1.50 and its March $51 Put is trading at $2.50.
Extrinsic Value Of Synthetic Short Call = $0 - $2.50 = $2.50 credit
Buy 1 contract of March $51 Call for $150 to complete the Reversal Arbitrage. Upon expiration, you will make the $100 credit ($250 - $150)
per position risk free.
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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.
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