Conversion Arbitrage

What Is Conversion Arbitrage?

Conversion arbitrage is an options trading strategy employed to take advantage of perceived shortcomings that might exist in the pricing of certain options. Conversion arbitrage is viewed as a risk-neutral strategy, by which a trader purchases a put and composes a covered call (on a stock that the trader as of now possesses) with indistinguishable strike prices and expiration dates.

A trader will endeavor to profit through a conversion arbitrage strategy when the call option is overpriced or the put is relatively underpriced. This can be due to market failures, or from the effects of mispriced interest rate presumptions. This strategy is most frequently accomplished through an options spread called a reverse conversion (or reversal conversion).

Conversion arbitrage ought not be mistaken for convertible arbitrage, which is a strategy including apparent mispricings in a convertible bond and its parts.

Understanding Conversion Arbitrage

Conversion arbitrage in options is an arbitrage strategy that can be embraced for the chance of a riskless profit when options are either theoretically overpriced or underpriced relative to one another and the underlying stock not entirely settled by the trader's pricing model.

To carry out the strategy, the trader will sell short the underlying stock and at the same time offset that trade with an equivalent synthetic long stock position (long call + short put). The short stock position conveys a negative 100 delta, while the synthetic long stock position utilizing options has a positive 100 delta, making the strategy delta neutral, or uncaring toward the direction of the market.

Illustration of How Conversion Arbitrage Works

For instance, if the price of the underlying security falls, the synthetic long position will lose value at precisely the same rate that the short stock position gains value; as well as the other way around. Regardless, the trader is risk-neutral, however profits might accrue as expiration draws near and the options' intrinsic value (time value) changes.

Conversion arbitrage works as a result of the hypothetical claim of put-call parity, in light of the Black-Scholes options pricing formula. Put-call parity proposes that, once completely hedged, calls and puts of a similar underlying, same expiration date, and same strike price — ought to be theoretically indistinguishable (parity). This is communicated by the accompanying articulation, where PV is the current value:

Call - Put = Price of underlying - PV(Strike)

In the event that the left half of the equation (call minus put price) is not the same as the right half of the equation, a potential conversion arbitrage opportunity exists.

Special Considerations

It is important to note that just on the grounds that it is called arbitrage, conversions are not without risks. Interest rates impact both carry costs and earnings on credit balances. Carrying costs additionally incorporate the amount of interest charged on debit balances.

Likewise with all arbitrage opportunities, conversion arbitrage is rarely accessible in the market. This is on the grounds that any opportunity for risk-free money is followed up on rapidly by the people who can spot these opportunities rapidly and push the market back in line. Also, since executing options and short-selling stock includes transaction costs, for example, broker fees and margin interest, apparent arbitrage opportunities may not exist in common sense.

There are important risk factors to bear as a main priority while thinking about arbitrage conversions; a couple of these incorporate a climb to interest rates and the elimination of dividends.

Features

• Conversion arbitrage endeavors to profit from relative mispricings among call and put options in a similar underlying security.
• Put-call parity recommends that there is a direct relationship between the prices of calls and puts for a similar strike price and expiration.
• In the event that this parity relationship is messed up in the market, traders can use a conversion arbitrage strategy.
• There are as yet important risk factors to bear as a top priority while thinking about arbitrage conversions, remembering a shift for interest rates or a change in dividends.