What is a Conversion Option Strategy?
The Conversion Option Strategy is an arbitrage trading strategy in which one is guaranteed profits regardless of how the market moves.
The opportunity for a conversion option strategy occurs very rarely, only when there is some disparity between the stock position and the synthetic stock position (also known as an option) that is large enough that it presents the opportunity for risk free trading.
In other words, it is a situation in which you buy a certain quantity of the option, and sell a certain quantity of the stock, or the inverse, and no matter where the price fluctuates to, the disparity between the option and the stock is such that you will always make a profit.
Generally, the profit will remain consistent as well, as is illustrated in the graph below.
Conversion Option Strategy vs Reverse Conversion Option Strategy
The difference between the Conversion Option Strategy and its counterpart is very simple, although perhaps overwhelming. The Conversion Option Strategy is used when it is believed that the option is overpriced, the Reversal is used when it is believed that the option is underpriced.
An oversimplified explanation of what you would do in each case is to sell the most expensive component and buy the cheapest.
How to Use the Conversion Option Strategy
It is important to note that, although most prefer to use the Conversion Option strategy to trade stocks and their options, it can also include the use of bonds, EFTs, futures and more.
This means that the use of the Conversion Options Strategy can be extremely diverse.
Calculating Conversion Option Strategy Opportunity with Price Parity
Price parity is an easy way to identify a Conversion Option Strategy Opportunity. Price Parity assumes that there is a continuous relationship between the call and put of the same strike price, with the same expiration date.
It is important that one can calculate when a disparity occurs. The following equation is generally used in order to determine price parity.
When this equation is not withheld there is an opportunity for an arbitrage trade.
How to Ensure Zero Risk with the Conversion Option Strategy
It is important that the call and the put option both have the same expiration date and the same strike price.
Thus, as the price discrepancy is locked in by purchasing and selling the option, the price of the options change at the same rate as the price of the stock. Any profit earned occurs immediately, and is maintained until the expiration of the options.
It is important to keep in mind that if any error has occurred, or if action was taken too late, then the mistake and thus the loss will also be locked in until the expiration of the options.
Buying and Selling Patterns for the Conversion Option Strategy
Because the rate of change is equal in the stock and the option, it is important that the number of stock shares is equal to the number of option shares, so that the initial profit can be maintained.
Observe the above equation of price parity again. Whichever side of the price parity equation is cheaper, would be the side where all the buying is done, and the side that is more expensive would be the side where all the selling is done, in order to achieve the initial profit.
At a $50 strike price, the call option of the stock is $51 and the put option is $50. A bond representing the underlying value of the stock is $50. This means that the left side of the equation is $1 while the right side is $0.
By selling what is more expensive (the left side of the equation), one realizes that you will have to short the call option and buy the put option.
Then on the other side you will buy the stock, and buy the bond that represents the underlying price.
This all together will give you an automatic profit of $1.
And, if you have the same quantities of stocks and options on either side, this profit will be maintained until the expirations of the bond and options.
The Pros of the Conversion Option Strategy
The biggest pro is that there is a guaranteed profit, regardless of the direction of movement in the stock price. This means that there is zero risk, and when trading in larger amounts this can be quite impactful.
This could be especially useful for market makers and hedge funds who have large amounts of money at their disposal.
The Cons of the Conversion Option Strategy
One con of the Conversion Option Strategy is that any profit that can be earned is limited. This means that more profits could have been obtained in a regular trade.
Additionally, the opportunities where arbitrage situations occur are very limited and tend to rectify them quickly, making them extremely difficult to spot and act upon before they disappear.
But, the biggest problem that traders run into with the Conversion Option Strategy is that their small but guaranteed profits are often offset by large quantities of fees and commissions.
It is almost impossible to calculate fees and commissions that are still associated with the trade accurately, and because four different trades occur there is little way to avoid them, even if lower commission trading platforms are used.
This means that the Conversion Option Strategy is not useful for traders using small amounts of money where the profit cannot offset the resulting loss.
Is the Conversion Option Strategy Reliable
The Conversion Option Strategy is 100% reliable. Any trades that have been placed correctly are guaranteed to work out with zero risk attached.
However, it definitely isn't for everyone. Because of the amount of experience that is required to successfully identify the rare occurrence, calculate the quantities required to trade, and the amount of money required to offset fees and commissions, the Conversion Option Strategy is not something recommended for everyone.
Instead, it is something that proves to be incredibly useful for seasoned traders, as well as for those trading large enough quantities of money that they can account for commissions.