Neutral Option Strategies » Reversal

Like the conversion and other arbitrage strategies, the reversal involves buying something in one market and simultaneously selling it in another to capitalize on whatever small discrepancy exists.

Reversals are primarily a Floor Trader strategy. Sometimes, to capitalize on minor price discrepancies between calls and puts, floor traders and other professionals will put on a trade known as a reverse conversion or reversal. As the name implies, this is exactly the opposite of a conversion.

Traders do reversals when options are relatively underpriced. To put on the position, the trader would sell stock on the open market and buy the options equivalent in the option market. When options are relatively overpriced, traders do conversions.

Theoretically, conversions and reversals have very little risk because the profit is locked in immediately. For this reason, traders will do conversions and reversals as many times as the market will allow.

The idea behind a reversal is to create what is known as a synthetic long position and offset it with a short position in the same underlying stock. The synthetic long position is created by buying a call and selling a put with the same strike price and expiration.

synthetic long position = long call + short put

Combining a synthetic long position with a short stock position creates a reversal:

long call + short put + short 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:

Option pricing
Option Bid Ask
August 100 Call $7.35 $7.50
August 100 Put $3.60 $3.75

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 underpriced with the stock at $104 because the synthetic long position (long call and short put) can be purchased for 3.90.

Thus, by selling the stock at $104, buying the call for 7.50 (the offer) and selling the put for 3.60 (the bid), the trader will lock in a .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.

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