A conversion is an arbitrage strategy in options trading that can be performed for a riskless profit when options are overpriced relative to the underlying stock. To do a conversion, the trader buys the underlying stock and offset it with an equivalent synthetic short stock (long put + short call) position.
|Long 100 Shares|
Buy 1 ATM Put
Sell 1 ATM Call
Profit is locked in immediately when the conversion is done and it can be computed using the following formula:
Profit = Strike Price of Call/Put - Purchase Price of Underlying + Call Premium - Put Premium
Suppose XYZ stock is trading at $100 in June and the JUL 100 call is priced at $4 while the JUL 100 put is priced at $3. An arbitrage trader does a conversion by purchasing 100 shares of XYZ for $10000 while simultaneously buying a JUL 100 put for $300 and selling a JUL 100 call for $400. The total cost to enter the trade is $10000 + $300 - $400 = $9900.
Assuming XYZ stock rallies to $110 in July, the long JUL 100 put will expire worthless while the short JUL 100 call expires in the money and is assigned. The trader then sells his long stock for $10000 as required. Since his cost is only $9900, there is a $100 profit.
If instead XYZ stock had dropped to $90 in July, the short JUL 100 call will expire worthless while the long JUL 100 put expires in the money. The trader then exercises the long put to sell his long stock for $10000, again netting a profit of $100.
For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.
However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).
If the options are relatively underpriced, the reversal is used instead to perform the arbitrage trade.
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