Options arbitrage
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Arbitrage trades are commonly performed by floor traders in the options market to earn small profits with very little or zero risk.
Traders perform conversions when options are relatively overpriced by purchasing stock and selling the equivalent options position. When the options are relatively underpriced, traders will do reverse conversions or reversals.
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[edit] Conversion
A conversion position is:
- short a call,
- long a put, and
- long the underlying
The call and put have the same strike value and expiration date. The resulting portfolio is delta neutral.
One reason a trader may take this position would be to extend the holding period of the underlying position for capital gains tax purposes, while locking in the current price.
[edit] Reversal
A reverse conversion or reversal is an option strategy that involves being
- long a call,
- short a put, and
- short the underlying.
The call and put have the same strike value and expiration date. The resulting portfolio is delta neutral.
[edit] Valuation of Reversals
The value of a reversal using at-the-money options is determined by calculating the benefits of the positions, and subtracting off the costs.
Benefits
- Receive short interest on the short position in the underlier.
- Receive long interest on the proceeds of selling the put.
Costs
- Pay long interest on the funds required to purchase the call.
- Pay any dividends or other obligations that accrue as a result of the short underlier position.
[edit] Example: Stock option reversal
The diagram illustrates the payoff at expiration for a reversal strategy using stock options and stock. Note that the long call and short put combination have the effect of creating a synthetic long stock position. This is balanced by the actual short stock position, resulting in a perfectly hedged portfolio.
[edit] See Also
[edit] References
- Option Arbitrage
- McMillan, Lawrence G. (2002). Options as a Strategic Investment, 4th ed., Prentice Hall. ISBN 0-7352-0197-8.
