By John Summa
While called arbitrage, conversions should not be construed as trades that never have any risk. Nevertheless, after identifying some major risk factors, we will present here some important steps toward reducing or even eliminating these factors. (Just because you're willing to accept a risk, doesn't mean you always should; check out Risk Tolerance Only Tells Half The Story to find out why.)
Assuming that a conversion strategist is able to lock in a small profit from buying the conversion (i.e, debit price is less than strike price), and that a reversal strategist is able to secure an arbitrage profit from sale of a reversal (i.e., credit price is greater than the strike price), we can now isolate the potential risks to this so-called arbitrage profit.
As we saw in Part 6 of this tutorial, dividends are a source of potential profit for the conversion strategist and a cost for the reversal strategist. Since dividends are never guaranteed (they can be cut or increased by company decision), the strategist cannot control this risk factor unless a policy of avoiding dividend paying stocks is adopted. Obviously, by not applying conversions and reversals to dividend-paying stocks, there is no risk for the conversion strategist. However, if a company announces it will begin paying a dividend and the declared dividend date falls before the reversal expires, the reversal strategist is going to have costs rise, and if these costs are greater than the initial arbitrage profit, this will result in a loss (unless interest is enough to offset that cost).
Dividends are a great source of potential profit for the conversion strategist, so it may make sense to do the proper research on dividend-paying stocks and try to capture that dividend payment in addition to any pure conversion profit. If risk is diversified and proper research is conducted, it may be possible to enhance potential gains well beyond the simple conversion arbitrage profit level in exchange for taking on dividend risk. However, keep in mind that conversion strategists earn more if a surprise dividend increase is declared. (Learn more in Dividends, Interest Rates And Their Effect On Stock Options.)
If there is an early assignment, resulting in the long stock position in a conversion being removed, no dividend will be earned and a conversion strategy dependent on earning that dividend may experience a loss. If the conversion was put on at exactly break even (strike price = debit charge to buy conversion), then the loss will be equal to the carry costs, which could be significant depending on when the early exercise occurs. If the conversion was established with enough profit to cover carry costs to term then there would be no loss (ignoring commissions, which we've done throughout this tutorial). There is also the issue of the left-over long put, which might have a little time premium left. If the long put is left open, it does have the potential to gain more value, or it could be liquidated to lock in what little value is left on it once the early assignment takes place. (Get more info in Profiting From Stock Declines: Bear Put Spread Vs. Long Put.)
One way to minimize this risk is to establish conversions that have substantial time value on the short call, which can be done by using options that expire well past the ex-dividend date (ex-date). But here, of course, there is a trade off because the longer you remain in the position past the ex-date, the larger your cost of carry. However, it may be possible to close the conversion following the ex-date and take a profit at that point, or hold the position open past another ex-date. If the call options are trading below parity before ex- date, there is a good chance they will be exercised. Any time value on the option (meaning it is above parity) when the stock goes ex-dividend, on the other hand, will likely prevent it from being exercised. (Find out how to keep your dividends out of the tax man's hands. Read Make Ex-Dividends Work For You.)
Reversals suffer from early assignment as well. Here, the short puts would be assigned thus removing short stock, credit balances and interest being earned daily. Depending on whether the position was established with a dependence on interest earnings for a profit, it could experience a loss, especially if a dividend risk was already incurred. If the interest earned was a substantial portion of the targeted profit, covering dividend fixed costs, then an early assignment might turn the trade into a loser. There is a left-over long call, which might gain value if held until expiration, one offsetting factor, if not closed.
We explored the subject of carry costs in the previous part of this tutorial. For conversion strategists, this takes the form of interest charged on debit balances, and this cost is not fixed. Each day, there are changes in market rates of interest and the benchmark rates used to compute a broker's carry charge for a conversion debit balance. Therefore, the conversion strategist has little control over this variable. (Learn which tools you need to manage the risk that comes with changing rates, read Manage Interest Rate Risk.)
Obviously, it's a good idea to allow room for carry rate increases in order to achieve an arbitrage profit. You may want to take on some dividend risk to buffer against expected rate increases when setting up a conversion. Here you might be adding dividend reduction or elimination risk, but if that seems less likely than a rate increase for your carry costs (usually these are tied to Fed funds rate), then this might make sense. Some strategist might hedge rising rates risk by shorting financial instruments that fluctuate with the Fed funds market to lock in a carry cost for the life of the trade. Meanwhile, the reversal strategist is not subject to carry costs and therefore avoids this risk.
There are no carry costs for reversal strategists. Instead, in their profit calculations, reversal strategists depend on the interest paid on credit balances. The best way to minimize this risk is to minimize the dependence on interest earned for the profitability of the strategy. If interest earned falls, it will reduce profit, but may not eliminate it. Another approach might be to invest (assuming you have that option) in interest-bearing instruments like CDs or Treasuries to lock in a rate on the credit balances, instead of letting them fluctuate throughout the life of the trade. Alternatively, if rates are expected to move higher over the life of the trade, it would be advantageous to not lock in a rate on interest earned on credit balances, so that with a rise in interest rates there would be additional profit potential on credit balances.
One last issue is the expiration day level of prices for the stock position, in either a conversion or reversal. If the price is well above the short call in the conversion, it is not an issue as the call is deep in the money (ITM) and will be automatically exercised, thus taking away the long stock position. Meanwhile, the long put expires out of the money (OTM). This is also not an issue if the call is out of the money and the put in the money. The put will be exercised and this removes the stock position. All is fine as long as you know one side will be in the money at expiration. (Learn more in Stock Option Expiration Cycles.)
If the stock is trading near the strike of the conversion on expiration day, a problem presents itself to the strategist. If the stock settles right on the strikes, not as rare as one might think, there will be no exercise of either put (for the reversal strategist) or call (for the conversion strategist). This means that the conversion strategist will be left with a long stock position (un-hedged) and the reversal strategist left with a short stock position (un-hedged) over the weekend, with all of the arbitrage trader's risk going into Monday's market open.
Essentially, the issue arises because it is not clear whether you will be assigned on short calls for the conversion strategist and short puts for the reversal strategist. While there are techniques available for reducing and even eliminating this risk, this will require diligent monitoring and adjusting (rolling) short legs on expiration day to minimize risk.
In this part of the tutorial, we have reviewed the major risk concerns for strategists using conversion and reversal strategies. Areas of risk for conversion strategists include dividend cuts, carry rate increases, early assignment and the stock price being equal to the strike price on expiration day. For the reversal strategist, the risks include surprise dividend increases, decreasing credit balance rate, early assignment and expiration day settlement prices for the stock being equal to the strike price used in the conversion. We've gone over the nature of these problem and some remedies for mitigation.
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