Conversion Arbitrage

Posted in Finance, Accounting and Economics Terms, Total Reads: 305

Definition: Conversion Arbitrage

Conversion Arbitrage is an option trading strategy that is used if there is some inefficiency in the pricing of a stock or security. Such opportunity are very difficult to spot and even more tough to trade as these are spotted early by the seasoned players and are traded upon till the actual balance is restored.

In this strategy, the trader will buy the put option and writes the call option of a stock (that he already owns) of the same expiry and identical strike prices. This way the trader is more or less risk neutral.

In case the price of the stock falls, the put value will rise offsetting the loss in the stock equal to the loss made in writing the call. In case of a price rise in the stock, both the call and the put options become worthless. However the trader is set to earn the profit which is equal to the price difference between the put purchase price and call writing price.

The movements in option prices are very fast and it is used mainly for hedging heavy portfolios.



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