Reversal

A reversal, or reverse conversion, is an arbitrage strategy in options trading that can be performed for a riskless profit when options are underpriced relative to the underlying stock. To do a reversal, the trader short sell the underlying stock and offset it with an equivalent synthetic long stock (long call + short put) position.

Reversal Construction
Short 100 Shares
Sell 1 ATM Put
Buy 1 ATM Call

Limited Risk-free Profit

Profit is locked in immediately when the reversal is done and it can be calculated using the following formula:

Profit = Sale Price of Underlying - Strike Price of Call/Put + Put Premium - Call Premium

Reversal Payoff Diagram
Graph showing the expected profit or loss for the reversal option strategy in relation to the market price of the underlying security on option expiration date.

Example

Suppose XYZ stock is trading at $100 in June and the JUL 100 call is priced at $3 while the JUL 100 put is priced at $4. An arbitrage trader does a reversal by short selling 100 shares of XYZ for $10000 while simultaneously buying a JUL 100 call for $300 and selling a JUL 100 put for $400. An initial credit of $10100 is received when entering the trade.

If XYZ stock rallies to $110 in July, the short JUL 100 put will expire worthless while the long JUL 100 call expires in the money and is exercised to cover the short stock position for $10000. Since the initial credit received was $10100, the trader ends up with a net profit of $100. 

If instead XYZ stock had dropped to $90 in July, the long JUL 100 call will expire worthless while the short JUL 100 put expires in the money and is assigned. The trader then buys back the obligated quantity of stock for $10000 to cover his short stock position, again netting a profit of $100.

Note: While we have covered the use of this strategy with reference to stock options, the reversal is equally applicable using ETF options, index options as well as options on futures.

Commissions

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).

Conversion

If the options are relatively overpriced, the conversion is used instead to perform the arbitrage trade.

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