Conversion

[Igor 10]

Traders who implement a conversion strategy are taking advantage of overpriced assets by instantly liquidating (arbitraging) them to fair market value. The technique involves selling and purchasing a put and a call option, at-the-money, while going long on the underlying asset. Traders can earn a small, risk-free profit when converting options, as long as the option's strike prices exceed the prices of the associated underlying asset.

 

Moneyness Review for Puts and Calls

 

Call Options:

 

In-The-Money (ITM) = Strike price (less than) Market Price

Out-of-The Money (OTM) = Strike price (more than) Market Price

 

Put Options:

 

In-The-Money (ITM) = Strike Price (more than) Market Price

Out-of-The Money (OTM) = Strike Price (less than) Market Price

 

Both Put and Call Options

 

At-The-Money (ATM) Strike Price (equals) Market Price

 

How to Carry Out A Conversion Strategy

 

 

Disney stock is worth $100 (market price) in June.

1) Trader buys 100 shares of Disney stock.

2) Trader buys the put option: DISJul100($3)

- 100 shares of Disney stock

- Strike Price $100, at-the-money (ATM), expiring in 30 days

- Premium Cost of $3

3) Trader sell the call option: DISJul100($4)

- 100 shares of Disney stock

- Strike Price $100, at-the-money (ATM), expiring in 30 days

- Premium Cost of $4

4) Trader pays $9900 to enter the conversion. [$9900 (paid for shares) + $400 (received from call) - $300 (paid for put)]

Total cost to enter the market: $9900

 

Result one: Disney stock rises (rallies) to $110 in July.

a) The put option purchased expires worthless. (OTM)

b) The call option sold expires ITM.

c) The investor who bought the trader's call option exercises his or her right to buy 100 shares at $100.

d) The trader uses the 100 shares to cover the assignment and receives $10000 from the buyer.

e) Trader gains a total of $100 after the subtracting the cost to enter the market from the funds collected from the call option. [$10000 (received from call buyer) - $9900 (cost to enter market)]

 

Result two: Disney stock falls to $90 in July.

a) The call option sold expires worthless. (OTM)

b) The put option purchased expires ITM.

c) The trader exercises his or her right to sell 100 shares at $100, receiving $10000 from the buyer for the long shares purchased when entering the trade.

d) The trader's profit totals $100 after the subtracting the cost to enter the market from the funds collected from the put option. [$10000 (received from put seller) - $9900 (cost to enter market)]

 

Calculating The Risk-Free Profit In A Conversion

 

Investors earn instant profits when correctly entering a conversion trade. Market conditions will not matter at the time of expiration, as the synthetic long position covers losses and cancels gains on the long trade. In order to achieve instant profits, the options' strike prices must exceed the difference in the price of the underlying asset less the cost to enter the market. [$100 = $100 (options' strike prices) - $100 (cost to enter market) + $100 (asset price)]

 

Advantages and Disadvantages of Implementing a Conversion :

 

Pluses: The upside to this type of strategy is that the investor will always make a small profit in any market situation, risk-free. The trader is just converting the overpriced options to fair market value.

 

Minuses: There is no downside in carrying out a reversal strategy, since it risk-free. However, traders must be able to recognize overpriced options of which values are higher than their associated underlying asset.