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Reverse Conversion

Reverse Conversion
TradingOptions and Derivatives TradingOptions and DerivativesAdvanced ConceptsAdvanced Options Trading Concepts

What is a Reverse Conversion?

A reverse conversion is a form of arbitrage that empowers options traders to profit from an overpriced put option regardless of what the underlying does. The trade consists of selling a put and buying a call to create a synthetic long position while shorting the underlying stock.

However long the put and call have the equivalent underlying strike price and expiration date, the synthetic long position will have a similar gamble/return profile as ownership of an equivalent amount of underlying stock. This means the trade (short stock and synthetically long the stock with options) is hedged, with the profit coming just from the mispricing of the option premiums.

Understanding Reverse Conversion

A reverse conversion is a form of arbitrage that empowers traders to capitalize on situations where the put is overpriced by selling a put, buying a call, and shorting the underlying stock. The call covers the short stock in the event that it transcends the strike price and the put is covered by the shorted stock assuming the stock price is not exactly the strike price. The profit while initiating these positions is the theoretical arbitrage gain from the position that comes from the overpriced put option.

Reverse conversion arbitrage is a type of put-call parity, which says that put and call option positions ought to be generally equivalent when paired with the underlying stock and T-bills, respectively.

To illustrate this concept, think about two situations:

  1. A trader that purchases one call option with a strike price of $100 and a T-bill with a face value of $10,000 that matures on the call's expiration date will continuously have a base portfolio value equivalent to $10,000.
  2. A trader that purchases one put option with a strike price of $100 and $10,000 worth of stock will continuously have a base value equivalent to the strike price of the put option.

Since traders are probably not going to affect interest rates, arbitrageurs take advantage of option price elements to guarantee that the put and call values equivalent out for a given asset. In fact, the put-call parity theorem is central to determining the theoretical price of a put option utilizing the Black-Scholes model.

Illustration of a Reverse Conversion

In a typical reverse conversion transaction or strategy, a trader short sells stock and hedges this position by buying its call and it its put to sell. Whether the trader brings in money relies upon the borrowing cost of the shorted stock and the put and call premiums. All of this might deliver a return better than a generally safe money market trade, which is where their capital would probably be stopped in the event that they can't track down worthwhile trades.

Expect it is June and a trader sees an overpriced October put in Apple (AAPL). The stock is currently trading at $190, thus they short 100 shares. They buy a $190 call and short a $190 put.

The call costs $13.10, while the put is trading at $15. This is a rare situation since puts typically cost not exactly equivalent calls.

Regardless of what happens the trader creates a gain of $190 ($15 - $13.10 = $1.90 x 100 shares), less commissions.

This is the way the situations could play out. The trader initially gets $19,000 from the stock short sale, as well as $1,500 from the sale of the put. They pay $1,310 for the call. Therefore, their net inflow is $19,190.

Accept Apple drops to $170 over the life of the option. The call terminates worthless, the short stock is assigned in light of the fact that the put buyer is in the money. The trader gives the shares at $190 costing $19,000. Another method for seeing it is that the put is losing $2,000 while the short stock is making $2,000. The two items net out at the strike price of $190, which is equivalent to $19,000 on a one contract (100 shares) position.

In the event that the price of Apple ascends to $200, the put option lapses worthless, the short position is covered at a cost of $20,000 ($200 x 100 shares) but the call option is worth $1,000 ($200 - $190 x 100 shares), netting the trader $19,000 in costs.

In both cases, the trader pays $19,000 to exit the position, but their initial inflow was $19,190. Their profit, whether Apple rises or falls, is $190. This is the reason this is an arbitrage trade.

Borrowing costs and commissions have been excluded in the model above for simplicity but are an important factor in reality. Consider, for instance, that assuming it costs $10 in commissions per trade, it will cost $30 to initiate the three required positions. The cost to exit will rely upon whether the options are practiced or on the other hand assuming the positions are exited prior to expiration. In either case, there will be additional costs to exit the trade, plus the borrowing costs on the shorted stock.

Highlights

  • A put option is typically less expensive, not more costly, than the equivalant call option. Therefore, finding a reverse conversion trade is rare.
  • A reverse conversion is an arbitrage situation in the options market where a put is overpriced or a call underpriced (relative to the put), resulting in a profit to the trader regardless of what the underlying does.
  • The reverse conversion is created by shorting the underlying, buying a call, and selling a put. The call and put have a similar strike price and expiry.