Conversion Arbitrage: Conclusion
  1. Conversion Arbitrage: Introduction
  2. Conversion Arbitrage: What Is It?
  3. Conversion Arbitrage: How Does It Work?
  4. Conversion Arbitrage: Forward Conversions
  5. Conversion Arbitrage: Reverse Conversions
  6. Conversion Arbitrage: Dividend Risk And Reward
  7. Conversion Arbitrage: Interest Risk And Reward
  8. Conversion Arbitrage: Other Risk Factors
  9. Conversion Arbitrage: Conclusion

Conversion Arbitrage: Conclusion

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.


  1. Conversion Arbitrage: Introduction
  2. Conversion Arbitrage: What Is It?
  3. Conversion Arbitrage: How Does It Work?
  4. Conversion Arbitrage: Forward Conversions
  5. Conversion Arbitrage: Reverse Conversions
  6. Conversion Arbitrage: Dividend Risk And Reward
  7. Conversion Arbitrage: Interest Risk And Reward
  8. Conversion Arbitrage: Other Risk Factors
  9. Conversion Arbitrage: Conclusion
RELATED TERMS
  1. Warrant

    A derivative that confers the right, but not the obligation, ...
  2. Bull Call Spread

    An options strategy that involves purchasing call options at ...
  3. Board Of Directors - B Of D

    A group of individuals that are elected as, or elected to act ...
  4. Crude Oil

    Crude oil is a naturally occurring, unrefined petroleum product ...
  5. Leg

    A leg is one component of a derivatives trading strategy, in ...
  6. Grant

    The issuance of an award, such as a stock option, to key employees ...
RELATED FAQS
  1. What is a derivative?

    A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, ... Read Full Answer >>
  2. What is after-hours trading? Am I able to trade at this time?

    After-hours trading (AHT) refers to the buying and selling of securities on major exchanges outside of specified regular ... Read Full Answer >>
  3. How do hedge funds use equity options?

    With the growth in the size and number of hedge funds over the past decade, the interest in how these funds go about generating ... Read Full Answer >>
  4. Can mutual funds invest in options and futures? (RYMBX, GATEX)

    Mutual funds invest in not only stocks and fixed-income securities but also options and futures. There exists a separate ... Read Full Answer >>
  5. How does a forward contract differ from a call option? (AAPL)

    Forward contracts and call options are different financial instruments that allow two parties to purchase or sell assets ... Read Full Answer >>
  6. How can an investor profit from a fall in the utilities sector?

    The utilities sector exhibits a high degree of stability compared to the broader market. This makes it best-suited for buy-and-hold ... Read Full Answer >>
Hot Definitions
  1. Liquidation Margin

    Liquidation margin refers to the value of all of the equity positions in a margin account. If an investor or trader holds ...
  2. Black Swan

    An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult ...
  3. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  4. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
  5. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
Trading Center