Conversion

A conversion is an arbitrage strategy in options trading that can be performed for a riskless profit when options are overpriced relative to the underlying stock. To do a conversion, the trader buys the underlying stock and offset it with an equivalent synthetic short stock (long put + short call) position.

Conversion Construction

Long 100 Shares Buy 1 ATM Put Sell 1 ATM Call

Limited Risk-free Profit

Profit is locked in immediately when the conversion is done and it can be computed using the following formula:

Profit = Strike Price of Call/Put - Purchase Price of Underlying + Call Premium - Put Premium

Example

Suppose XYZ stock is trading at $100 in June and the JUL 100 call is priced at $4 while the JUL 100 put is priced at $3. An arbitrage trader does a conversion by purchasing 100 shares of XYZ for $10000 while simultaneously buying a JUL 100 put for $300 and selling a JUL 100 call for $400. The total cost to enter the trade is $10000 + $300 - $400 = $9900.

Assuming XYZ stock rallies to $110 in July, the long JUL 100 put will expire worthless while the short JUL 100 call expires in the money and is assigned. The trader then sells his long stock for $10000 as required. Since his cost is only $9900, there is a $100 profit.

If instead XYZ stock had dropped to $90 in July, the short JUL 100 call will expire worthless while the long JUL 100 put expires in the money. The trader then exercises the long put to sell his long stock for $10000, again netting a profit of $100.

Note: While we have covered the use of this strategy with reference to stock options, the conversion is equally applicable using ETF options, index options as well as options on futures.

Commissions

For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.

However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).

Reverse Conversion (Reversal)

If the options are relatively underpriced, the reversal is used instead to perform the arbitrage trade.

You May Also Like

Continue Reading...

Buying Straddles into Earnings

Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results....[Read on...]

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount....[Read on...]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time.....[Read on...]

Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®.... [Read on...]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date....[Read on...]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative....[Read on...]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date....[Read on...]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin....[Read on...]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading.... [Read on...]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator.... [Read on...]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa.... [Read on...]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as "the greeks".... [Read on...]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow.... [Read on...]

Follow Us on Facebook to Get Daily Strategies & Tips!

Options Arbitrage

Synthetic Positions

Options Strategies

Options Strategy Finder

Outlook on Underlying:
Arbitrage Bearish Bullish Neutral - Bearish on Volatility Neutral - Bullish on Volatility

Profit Potential:
Limited Unlimited

Loss Potential:
Limited Unlimited

Credit/Debit:
Credit Debit

No. Legs:
1 2 3 4