On this page today, we shall learn about conversion strategy. The conversion option strategy is used when you are involved in options arbitrage. This strategy is utilized to gain riskless profit when the options are overpriced in relation to the price of the underlying stock.
Conversion arbitrage options strategy generally exploits the market inefficiencies in the pricing of the options. This strategy is risk-neutral because a trader buys a put option contract and sells a covered call option with the same strike price and expiry dates.
Traders can profit using this strategy when either call or put options are mispriced. The misprice can be due to various reasons, such as market inefficiency or wrong interest rate assumptions.
The conversion strategy can be utilized when the call options are overpriced and put options are underpriced.
There are six synthetic positions that can be created using various combinations of call options, put options, and the stock price of the underlying asset.
Synthetic long stock = long call option + short put option contract
Synthetic short stock = short call option + Long put option contract
Synthetic long call = Long stock + long Put
Synthetic short call = short stock + short Put
Synthetic short Put = short call + long stock
Synthetic long Put = long call option contract + short stock
To construct a conversion strategy, traders need the following:
Long 100 shares
Buy 1 ATM put option contract
Sell 1 ATM put option contract
Highest profit on the strategy:
When the trader enters the conversion strategy, the profit gets locked immediately, and the same can be counted using the below formula:
Profit = Strike price of a call or Put option - purchase price of the underlying asset + premium paid from the call option - Premium received from put options.
Let us understand with an example:
Suppose the ABC stock is currently trading at ₹100 in June, month, and July call option is priced at ₹4, and July 100 put option is priced at ₹3. Here, the trader takes advantage of the mispriced options and enters the conversion strategy. Traders buy 100 shares of ABC for ₹10,000 and also buy a July put option at ₹300 and sell July 100 call for ₹400.
The total cost would be as follows: ₹10,000 +₹300 - ₹400 = ₹9,900.
Let us assume the ABC stock rallies to ₹110 in July, then the long July 100 put will expire worthless, and the July 100 call expires ITM and gets assigned. The trader sell his long stock for ₹10,000, and because his cost to enter the strategy was only ₹9,900, subtracting the cost, we will get ₹100 as a profit.
Let us assume another scenario in which, instead of a price rise, the price of the underlying asset falls to ₹90 in July. In this case, the short July call will expire worthless, and the long July 100 put options will expire ITM. Here, the trader can exercise the long Put and sell the long stock for ₹10,000 and gets a net profit of ₹100.
If you are not an arbitrage trader, please refrain from using this strategy.
The commissions for such types of reversals are generally high. Thus confirming the commission with your broker before entering this type of strategy would be a wise step.
This strategy can be more profitable if you are trading with a high number of option contracts.
Thus, we have seen that if there is an arbitrage opportunity in options trading, which strategy to apply to make a profit and limit the loss? If you have any questions or queries, kindly let us know at 8447445815 / 9909978783.