Conversions are primarily a Floor Trader strategy. To capitalize on minor price discrepancies between calls and puts, floor traders and other professionals will sometimes put on a trade known as a conversion.
Like all arbitrage strategies, the conversion involves buying something in one market and simultaneously selling it in another to capitalize on whatever small discrepancy exists.
Traders do conversions when options are relatively overpriced. To put on the position, the trader would buy stock on the open market and sell the equivalent position in the option market. When the options are relatively under-priced, traders will do reverse conversions, otherwise known as reversals.
Theoretically, conversions and reversals have very little risk because the profit is locked in immediately.
The synthetic short position is created by selling a call and buying a put with the same strike price and expiration.
synthetic short position = short call + long put
Combining the synthetic short position with a long stock position creates a conversion:
Short call + long put + long stock
To see how this might work, imagine that a stock is trading at $104. At the same time, the options are priced as follows:
|August 100 Call||$7.60||$7.75|
|August 100 Put||$3.35||$3.50|
In the absence of any price discrepancies, the following will be true:
Call price - put price = stock price - strike price
In other words, if the stock is trading for $104, the 100 calls - the 100 puts should equal $4. At the prices above, this calls and puts are relatively overpriced because the synthetic short position (short call and long put) can be done at 4.10.
Thus, by buying the stock for $104, selling the call for 7.60 (the bid) and buying the put for 3.50 (the offer), the trader will lock in an .1 point profit.
Individual investors and most other off-the-floor traders don't have an opportunity to do conversions and reversals because price discrepancies typically only exist for a matter of moments. Professional option traders, on the other hand, are constantly on the lookout for these opportunities. As a result, the market quickly returns to equilibrium.