Conversions And Reversals
Last week I described synthetic longs and shorts. In the past I have mentioned that puts and calls with the same strike and expiration almost always have approximately the same implied volatility. The reason for this is closely related to synthetics.
Suppose you have a synthetic short–long an at-the-money put and short an at-the-money call. If you then purchase the underlying, you have a position that is short the underlying (your synthetic short) and long the underlying (your actual long), thus totally neutral. If you look at the mechanics of this position, you will see it does not matter where the stock price is at expiration–the position will be worth nothing at that time, neither a credit nor a debit. This position, an actual long and a synthetic short, is called a conversion–it converts a long position in the underlying to a neutral position.
Why would anyone want to do that? Suppose the put and call prices differed greatly, and that you could purchase the put for much less than the premium that you would receive from writing the call. If you look at the mechanics of the synthetic, you would see you would make a riskless profit of that difference.
There are traders who specialize in conversions, who look for extraordinary opportunities where the rate of return on this trade is exceptional. When they see calls selling for too much in relation to the corresponding put, they buy the puts, sell the calls and buy the underlying, pushing up the put price and pushing down the call price and thereby ensuring that the put and call prices do not get too far out of line with one another.
These “converters” likewise watch for situations where the put is much more expensive than the call, and when they see such a situation they sell the puts and buy the calls and sell the stock short, combining a synthetic long with an actual short. This position is called a reverse conversion, or a reversal. The activities of the converters likewise insure that puts don’t sell for too high a price relative to the corresponding call.
When puts were first introduced, you could regularly find conversions yielding 20%-30% and even more, on an annualized basis. There were even firms that dealt exclusively in conversions and reversals. But as the market became more sophisticated, these opportunities disappeared.
Today, when almost every market maker knows how to construct this position and is a potential converter, many of the conversion firms have largely turned their attention elsewhere, as the supply of good conversions and reversals is almost non-existent. So you should not waste any time looking for conversions or reversal opportunities, but should be aware of the presence of converters. You can count on them.
Last Thursday I left you with a puzzle. If the underlying is selling for $60 and you use the 50 put and call to create synthetic long, buying the call and selling the put, your synthetic long essentially buys the underlying for $50, and it looks like you have put $10 in your pocket. However, the 50 call will cost you somewhat more than $10, whereas the 50 put will not bring you much premium as it is quite out of the money. So your net outlay will be about $10 for the right to purchase the underlying for $50, what you would expect.