Reversal

Reversal is similar with the arbitrage and conversion strategies. This involves purchasing one option and selling another to make money from the difference between the two.

This strategy is often used by traders to take advantage of price difference between the calls and the puts. Here you will put a trade that is the reverse of conversion, hence the name. This is the reason why it is also called reversal or reverse conversion.

You can create a reversal when the stock is underpriced. To do this, you will have to sell stock and then purchase the option for that stock. Floor traders do this often when the stock is relatively overpriced.

Similar with the conversion, this is a low risk strategy. Since the profit is very limited, many traders do this often to make money from the strategy. The principle behind this strategy is to create a synthetic long position and then offsetting that position with another short position. To do this, you will have to buy a call and then sell a put with the same strike prices and expiration dates. Here is the simple formula for this:

synthetic long position = long call + short put

By combining the two, you then create a reversal. Here is the formula:

long call + short put + short stock

For example, supposing stock ABC is trading at $208 and the options are priced:

Without the difference between the two, it would be:

call price – put price = stock price – strike price

Thus, if the stock is trading at $208, the calls less the put would be $8. With this, the puts are now underpriced because the long and call put can now be bought at $7.80. So, by selling the stock at $308, purchasing the call for $15 and then selling the put for $7.20, you will lock in a .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 the reversals and conversions.