By John Summa
As we have seen, conversions and reversals involve combining three legs in complex options combination strategy aimed at establishing an arbitrage profit. We have demonstrated that at a stripped-down level of the options, it is simply a way to lock in a net time-value credit.
In practice, this is a positive theta (time-value decay rate) trade where time-value decay works in our favor, as the options premium declines to zero at expiration. As long as we are not net buyers of time premium, with a conversion or reversal, we can have our profit, at least in the simplified model used in the tutorial. (To learn more about arbitrage, check out Trading The Odds With Arbitrage.)
The simple model we initially worked with abstracted from carry costs and other cost and risk factors so we could isolate the core idea. Once that was done, we moved to adding in additional variables, namely dividends, interest rates and cost of carry. Here we saw that we need to pay special attention to the carry rates of interest, as well as dividends that might be paid (for conversions) or charged (for reversals) to our trading account.
Conversions are a buying strategy and reversals are a selling strategy, which creates some interesting differences not apparent on the surface. Reversals, we showed, have potential to earn interest on their credit balances. Conversions, meanwhile, provide a way to capture dividends, and this too can be a sizable portion of potential profitability. Both, of course, are not risk free and may turn arbitrage profits into losses.
Last, we looked at various risk factors that both conversions and reversals carry with them, and as a result saw that the simple model can get quite complex in terms of different determinants of the outcomes to these combination strategies. (Read more in Do Option Sellers Have A Trading Edge?)
For conversions, the key risks include: surprise cuts to or elimination of dividends, interest rate increases, early exercise and strike price proximity to the underlying on expiration day. Key reversal risks include: surprise dividend increases or declarations of a dividend to be paid on a stock not paying a dividend, interest rate decreases, early exercise and proximity of the underlying to the strike price of the reversal on expiration day. (Check out Going Long On Calls to learn how to buy calls and then sell or exercise them to earn a profit.)
While an entire book could be written on this topic, the core concept of a conversion and reversal can be grasped with this tutorial. For additional reading on the topic, one might wish to read Larry McMillan's Options As A Strategic Investment, which provides discussion on the topic of conversions and related strategies.
Keep in mind that this approach to trading options requires attention to a number of variables and is not a guarantee of profit. Even with an arbitrage profit on the position, it is possible to lose money with these trades. Yet with responsible management of the strategy, and putting in the time to do proper research, these risks can be minimized and made manageable.
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