Options Arbitrage: Conversion-Reversal

Conversion-Reversal is a set of arbitrage strategies which are used when options are over-priced or under-priced.

Contents

Executing Conversion Strategy

To do a conversion, the trader buys the underlying stock futures and offset it with an equivalent synthetic short stock (long put + short call) position. The risk free profit is locked in immediately when the 3-leg conversion trade is executed. The profit can be booked when the arbitrage opportunity case to exit or at the expiry of derivatives.

The profit is calculated as:
Profit = Strike Price of Call/Put – Purchase Price of Underlying + Call Premium – Put Premium

Executing Reversal Strategy

To do a reversal, the trader short sell the underlying stock futures and offset it with an equivalent synthetic long stock futures (long call + short put) position. The risk free profit is locked in immediately when the 3-leg reversal trade is executed. The profit can be booked when the arbitrage opportunity case to exit or at the expiry of derivatives.

The profit is executed as:
Profit = Sale Price of Underlying – Strike Price of Call/Put + Put Premium – Call Premium

Conversion-Reversal in India

The conversion-reversal arbitrage can be done by using the 3-leg strategies provided by leading software vendors- Omnesys, Greeksoft and Apama. The consting of the strategy is determined by the broker and usually available at Rs. 5000 per month for non co-located system.

Conversion-Reversal Profitability

The conversion-reversal arbitrage yields high returns because options intrinsically go from a phase of under-pricing to over-pricing. However, it is advisable to execute the strategies only in ulta low latency system to stay ahead of competition.