Conversion & Reversal Arbitrage is an options arbitrage strategy which takes advantage of discrepancies in the value of synthetic positions and their represented equal in order to return a risk-free profit.
You need a comprehensive knowledge of options arbitrage as well as synthetic positions before you can fully understand Conversion & Reversal Arbitrage.
Conversion & Reversal Arbitrage takes advantage of dramatic breaches in Put Call Parity resulting in significant differences in the value of a synthetic position and the actual position that it represents. For example, when the value of a synthetic long stock is significantly different from the underlying stock itself, a Conversion / Reversal Arbitrage opportunity exists. Such opportunities are extremely rare in options trading, gets filled out and corrected quickly and may not result in enough profits to justify the commissions paid. That is why Conversion & Reversal Arbitrage remains the domain of professional options traders such as floor traders and market makers who need not pay broker commissions.
Synthetic positioning allows an open options trading position to be synthetically closed without selling the position itself. For example,
a synthetic long stock can be synthetically closed by shorting a corresponding amount of the actual stock. Synthetically closed positions are no longer be subject to
directional risk
and serves to
hedge against short term price swings.
| Synthetic Position | Components | Closing Instrument | Classification |
| Synthetic Long Stock | Long Call + Short Put | Short Stock | Reversal |
| Synthetic Short Stock | Short Call + Long Put | Long Stock | Conversion |
| Synthetic Long Call | Long Stock + Long Put | Short Call | Conversion |
| Synthetic Short Call | Short Stock + Short Put | Long Call | Reversal |
| Synthetic Long Put | Short Stock + Long Call | Short Put | Reversal |
| Synthetic Short Put | Short Call + Long Stock | Short Put | Conversion |
When a position is synthetically closed using Conversion & Reversal, it is subjected only to theta risk, which is time decay on the extrinsic value of the long options involved in the position.
When put call parity is in force perfectly, the total amount of extrinsic value in the synthetic position
should be exactly the same as the amount of extrinsic value in the actual instrument. For instance, a synthetic long stock should have
no extrinsic value at all as the
premium of the put option cancel
out the premium of the call option involved. A synthetic long call
should have the same amount of extrinsic value as the actual call option itself. However, there are conditions when Put Call Parity is so severely violated that a significant difference in extrinsic value exist between a synthetic
position and its actual instrument. When such a position is synthetically closed out, a profit results from that difference in
extrinsic value upon expiration when a Conversion or Reversal is used. This is known as Conversion /
Reversal Arbitrage.
When a significant difference in total extrinsic value exists between a financial instrument and its synthetic equal. We will focus this tutorial on just 4 examples; Synthetic Short Stock Conversion Arbitrage, Synthetic Long Stock Reversal Arbitrage, Synthetic Long Call Conversion Arbitrage and Synthetic Short Call Reversal Arbitrage.
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Synthetic Short Stock Conversion Arbitrage Example :
Assuming ABC company's shares are trading at $51 and its March $51 Call is trading at $2.50 and its March $51 Put is trading at $1.50. Extrinsic Value Of Short Stock = $0 |
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Synthetic Long Stock Reversal Arbitrage Example :
Assuming XYZ company's shares are trading at $51 and its March $51 Call is trading at $1.50 and its March $51 Put is trading at $2.50. Extrinsic Value Of Synthetic Long Stock = $1.50 - $2.50 = $1.00 credit Extrinsic Value Of long Stock = $0 There is a $1.00 difference in extrinsic value between the Synthetic Long Stock and the actual Stock, therefore, Reversal Arbitrage is also possible. |
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Synthetic Long Call Conversion Arbitrage Example :
Assuming XYZ company's shares are trading at $51 and its March $51 Call is trading at $2.50 and its March $51 Put is trading at $1.50. Extrinsic Value Of Synthetic Long Call = $0 + $1.50 = $1.50 Extrinsic Value Of long Call = $2.50 There is a $1.00 difference in extrinsic value between the Synthetic Long Call and the actual Call option, therefore, Conversion Arbitrage is possible. |
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Synthetic Short Call Reversal Arbitrage Example :
Assuming XYZ company's shares are trading at $51 and its March $51 Call is trading at $1.50 and its March $51 Put is trading at $2.50. Extrinsic Value Of Synthetic Short Call = $0 - $2.50 = $2.50 credit Extrinsic Value Of Short Call = $1.50 There is a $1.00 difference in extrinsic value between the Synthetic Short Call and the actual Short Call option, therefore, Reversal Arbitrage is also possible. |
Simply conduct Conversion or Reversal to synthetically close out the original position.
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Synthetic Short Stock Conversion Arbitrage Example :
Assuming ABC company's shares are trading at $51 and its March $51 Call is trading at $2.50 and its March $51 Put is trading at $1.50. Extrinsic Value Of Synthetic Short Stock = $1.50 - $2.50 = $1.00 credit Buy 100 shares of ABC stock to complete the Conversion Arbitrage. Upon expiration, you will make $100 ($1 x 100) per position risk free. |
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Synthetic Long Stock Reversal Arbitrage Example :
Assuming XYZ company's shares are trading at $51 and its March $51 Call is trading at $1.50 and its March $51 Put is trading at $2.50. Extrinsic Value Of Synthetic Long Stock = $1.50 - $2.50 = $1.00 credit Short 100 shares of XYZ stock to complete the Reversal Arbitrage. Upon expiration, you will make the $100 ($1 x 100) credit per position risk free. |
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Synthetic Long Call Conversion Arbitrage Example :
Assuming XYZ company's shares are trading at $51 and its March $51 Call is trading at $2.50 and its March $51 Put is trading at $1.50. Extrinsic Value Of Synthetic Long Call = $0 + $1.50 = $1.50 Short 1 contract of March $51 Call for a credit of $250 to complete the Conversion Arbitrage. Upon expiration, you will make the $100 credit ($250 - $150) per position risk free. |
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Synthetic Short Call Reversal Arbitrage Example :
Assuming XYZ company's shares are trading at $51 and its March $51 Call is trading at $1.50 and its March $51 Put is trading at $2.50. Extrinsic Value Of Synthetic Short Call = $0 - $2.50 = $2.50 credit Buy 1 contract of March $51 Call for $150 to complete the Reversal Arbitrage. Upon expiration, you will make the $100 credit ($250 - $150) per position risk free. |
A properly executed Conversion & Reversal Arbitrage has zero chance of a loss no matter how the underlying stock moves.
Maximum Profit = Net credit resulting from the execution
(During expiration of the options involved)
Maximum Profit: Limited
Maximum Loss: No Loss Possible
:: Able to obtain risk-free profits.
:: Conversion & Reversal Arbitrage opportunities are extremely hard to spot as price discrepancies are filled very quickly.
:: High broker commissions makes Conversion & Reversal Arbitrage difficult or plain impossible for amateur trader.
:: Resulting credit spread position means that traders with low trading level may not be able to put on such a position.
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