Conversion Arbitrage: What Is It?
By John Summa
Conversions involve combining three legs in a complex options strategy that can best be understood in terms of the concept of time value spreading, which is explained below. Typically, conversions are explained in terms of their cost (purchase price) for establishing the position (stock price plus put price minus sale of call). Here we speak of a forward conversion (reverse conversions are discussed below). Throughout this tutorial, we will refer to forward conversions simply as conversions and reverse conversions as reversals. The price paid for a conversion is the amount you pay to establish the position, thus entailing a net cash outlay (debit to the trading account).
Locking in a Time-Premium Credit
A conversion is created by buying or holding a position in a company's stock, then selling call options and buying put options at the same strike price and expiration date as the call options. If this can be executed for a net time-premium credit on the call and put options, you will have locked in a profit no matter where the stock trades before expiration day. You can think of it as a synthetic short (same strike short call/long put) hedged with a long stock position. (Learn more about arbitrage in Put-Call Parity And Arbitrage Opportunity.)
While we are abstracting from some complicating factors, this simplistic model does provide a way to grasp the basic idea in order to get started. Often the conversion idea is presented in terms of the price of buying the options (debit cost) in relationship to the strike of the options. If the cost (purchase price) is less than the strike price, then an arbitrage profit is established. This amounts to the same thing as locking in a time-value credit across the two options, as will be demonstrated in subsequent parts of this tutorial. In the section of this tutorial specifically addressing conversions, some examples are presented to make the idea of locked-in profit more tangible.
The related strategy of reverse conversions (reversals) involves exactly what the name implies, the reverse of a conversion. Here the arbitrageur will be selling the stock short, and then buying calls and selling same-strike, same-month puts. As with a conversion, if this can be executed for a net time-premium credit between the call and put options; there is a locked-in profit for the strategist no matter where the stock trades by options expiration day. Again, we are abstracting from some complicating factors to be addressed later.
Adding Dividends to the Story
As the reader will see, when moving to a more complex understanding of the conversion and reversal, dividends can play a key role in determining potential profit and loss, and while it is possible to remove or at least reduce the dividend risk from the strategy, it will alter the profit potential.
Additionally, the cost of carry is a feature of this strategy that will be incorporated as we move closer to the full model without any oversimplifications. Cost of carry comes into play in conversions, but not reversals. Reversals create a credit balance and are thus free of a cost of carry (interest paid on debit balance). In fact, reversals are strategies that allow for capturing interest payments on the cash proceeds of the short sales in the reversal itself. These interest earnings are then factored into the equation for determining ultimate profitability. (Learn more about interest rates in How Interest Rates Affect The Stock Market.)
However, like dividend payments in conversions, there is no guarantee that interest payments will remain fixed, thus opening a degree of potential risk to the reversal arbitrageur. If the arbitrageur, however, is establishing conversions or reversals by taking the proper steps regarding dividend risk and interest rate risk, it is possible to minimize these potential pitfalls, as will be demonstrated in subsequent sections of this tutorial. (To learn more, check out The Importance Of Dividends.)
Conversions involve locking in an arbitrage profit with a long stock purchase combined with short sale of a call and purchase of a same-strike put with the same expiration date. Reversals involve selling stock short, selling a put and purchasing a same-strike call with the same expiration date. We've just gone over the general idea of conversions and reversals. In the following segment, we look at the pricing structure of a conversion and what makes it work as an arbitrage trade.
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