*4 Reasons To Hold Onto An Option.)*

**TUTORIAL: Conversion Arbitrage****Adjustments for American Options**

This relationship is strictly for European-style options, but the concept also applies to American-style options, adjusting for dividends and interest rates. If the dividend increases, the puts expiring after the ex-dividend date will rise in value, while the calls will decrease by a similar amount. Changes in interest rates have the opposite effects. Rising interest rates increase call values and decrease put values. (To learn the difference between European and American options, see

*How do you tell whether an option is American or European style?)*

**The Synthetic Position**

Option-arbitrage strategies involve what are called synthetic positions. All of the basic positions in an underlying stock, or its options, have a synthetic equivalent. What this means is that the risk profile (the possible profit or loss), of any position, can be exactly duplicated with other, but, more complex strategies. The rule for creating synthetics is that the strike price and expiration date, of the calls and puts, must be identical. For creating synthetics, with both the underlying stock and its options, the number of shares of stock must equal the number of shares represented by the options. To illustrate a synthetic strategy, let's look at a fairly simple option position, the long call. When you buy a call, your loss is limited to the premium paid while the possible gain is unlimited. Now, consider the simultaneous purchase of a long put and 100 shares of the underlying stock. Once again, your loss is limited to the premium paid for the put, and your profit potential is unlimited if the stock price goes up. Below is a graph that compares these two different trades.

**Arbitrage Using Conversion and Reversals**

We can use this idea of the synthetic position, to explain two of the most common arbitrage strategies: the conversion and the reverse conversion (often called a reversal). The reasoning behind using synthetic strategies for arbitrage is that since the risks and rewards are the same, a position and its equivalent synthetic should be priced the same.

*Trading The Odds With Arbitrage.)*

**Conclusion**

A put-call parity is one of the foundations for option pricing, explaining why the price of one option can't move very far without the price of the corresponding options changing as well. So, if the parity is violated, an opportunity for arbitrage exists. Arbitrage strategies are not a useful source of profits for the average trader, but knowing how synthetic relationships work, can help you understand options while providing you with strategies to add to your options-trading toolbox. (To learn more, see

*Understanding Option Pricing.)*