CONVERSIONS & REVERSALS

Conversions and Reversals are the trader's favorite tool for risk management. It is most accurately described as a quasi-arbitrage that options traders rely on for pricing purposes as well as for its risk management functions. The synthetic relationships that puts and calls have to each other has already beer seen in the previous section. This relationship is known as 'Put/Call Parity'.

I. Conversions/Reversals - the traders pricing/risk management tool A. Structure: CONVERSION

• UNDERLYING
• PUT
• CALL REVERSAL
• UNDERLYING
• PUT
• CALL

*The calls and puts used in the C/R need to be of the same expiration month and the same strike price.

B. Effect on your position if:

1. the underlying rallies?
2. the underlying breaks?
3. the underlying remains unchanged?
4. time passes?
5. volatility increases/decreases?

II. Fair Value Pricing Equation A. In Indexes & Futures

where: X+C =F+P+B (when the Put is ITM) X+C+B=F+P (when the Call is ITM)

B. IN EQUITIES

X+C = S+P+(B-D) where; X = Strike Price C = Call Price S = Stock Price P = Put Price B = Banking D = Dividends

1.The Banking calculation is as follows: X x Interest Rate x (Days to Expiration/360)

2. The Comparative Interest rate of the position is: Conversion Price x (360/# of Days) x 100

III.Relative Pricing Theory Relative pricing is a very important concept for anyone dealing with options. It allows the market participant to value options based off the prices of other options rather than theoretical. In this manner an option truly fair-valued to the market and what is trading. This is achieved through the use of simple formulas and the options traders' tools:

Conversions, Reversals, Boxes, Synthetics