Conversion is basically a floor trader strategy. The principle behind this strategy is known as creating a synthetic short position and then offsetting it with long position of the same stock.
Floor traders, in order to make money from the position take advantage of the calls and the puts. Similar with the arbitrage strategy, this involves purchasing one option and selling another and them making money from the differences of the two. Regardless of how small the differences, traders use this to have profit from the differences.
Investors use this when the options are overpriced. To create a conversion, you will have to purchase one stock and then selling the equivalent position. When the options are underpriced, you can do a reversal. Both the conversion and the reversal are low risks while the profit is locked in.
To create a synthetic short position, you will have to sell a call and then buy a put with the same strike prices and expiration date. Here is the formula:
synthetic short position = short call + long put
You can create a conversion by adding the synthetic short position with the long stock position. Here is the formula:
Short call + long put + long stock
For example, if stock ABC is trading at $208 and the options are priced at:
|August 100 Call||$15.20||$15.50|
|August 100 Put||$6.70||$7|
Without the difference between the two, this would be:
Call price – put price = stock price – strike price
In short, if the stock is trading at $208, the calls less the put would be the same. With the prices above, the calls and the puts are overpriced because the short and the long put can be at 8.20. Therefore, by purchasing the stock at $208, selling the call and buying the put, you can lock in at .1 point profit.
Since price discrepancies exist for a short period, many investors and traders do not have as much opportunity as they want to create conversions and reversals. However, regular traders are always on the lookout for both.
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