What Is Conversion Arbitrage?
Conversion arbitrage is an options trading strategy employed to exploit perceived inefficiencies that may exist in the pricing of options. Conversion arbitrage is considered to be a risk-neutral strategy, whereby a trader buys a put and writes a covered call (on a stock that the trader already owns) with identical strike prices and expiration dates.
A trader will profit through a conversion arbitrage strategy when the call option is overpriced or the put is underpriced. This can be due to market inefficiencies, or from the effects of mispriced interest rate assumptions. This strategy is sometimes called a reversal-conversion (or reverse conversion).
There are important risk factors to bear in mind when considering arbitrage conversions; a few of these include a hike to interest rates and the elimination of dividends.
Understanding Conversion Arbitrage
Conversion arbitrage in options is an arbitrage strategy which can be undertaken for the chance of a riskless profit when options are either theoretically overpriced or underpriced relative to the underlying stock—as determined by the trader's pricing model.
To implement the strategy, the trader will sell short the underlying stock and simultaneously offset that trade with an equivalent synthetic long stock position (long call + short put). The short stock position carries a negative 100 delta, while the synthetic long stock position using options has a positive 100 delta, making the strategy delta neutral, or insensitive to the direction of the market.
- It is important to note that just because it is called arbitrage, conversions are not without risks.
- Interest rates impact both carry costs and earnings on credit balances.
- Carry costs also include the amount of interest charged on debit balances.
- There are important risk factors to bear in mind when considering arbitrage conversions, including a hike to interest rates and the elimination of dividends.
Example of How Conversion Arbitrage Works
For example, if the price of the underlying security falls, the synethetic long position will lose value at the exact same rate that the short stock position gains value; and vice-versa. In either situation, the trader is risk neutral, but profits may accrue as expiration approaches and the options' intrinsic value (time value) changes.
Conversion arbitrage works because of the theoretical claim of put-call parity, based on the Black-Scholes options pricing formula. Put-call parity suggests that, once fully hedged, calls and puts of the same underlying, same expiration date, and same strike price—should be theoretically identical (parity). This is expressed by the following expression, where PV is the present value:
- Call - Put = Price of underlying - PV(Strike)
If the left side of the equation (call minus put price) is different than the right side of the equation, a potential conversion arbitrage opportunity exists.
As with all arbitrage opportunities, conversion arbitrage is rarely available in the market. This is because any opportunity for risk-free money is acted on very quickly by those who can spot these opportunities quickly and push the market back in line. Additionally, since executing options and short selling stock involves transaction costs such as broker fees and margin interest, apparent arbitrage opportunities may not exist in practicality.