Don’t Be The Little Brother

April 12th, 2013
in contributors

Online Trading Academy Article of the Week

by Russ Allen, Online Trading Academy Instructor

In my articles for the last two weeks, which you can read here and here, I wrote about different option positions that are synthetic equivalents of each other. This means that although they were constructed from different ingredients, they resulted in the same profit or loss at each price of the underlying asset – thus they were functionally the same. I showed that with the right choice of strike prices, owning a long call on its own is really the same thing as buying stock and a protective put; and that a short put all by itself is really the same thing as owning stock and selling a covered call. I demonstrated that we can always produce a synthetic equivalent for any underlying position, or for any option position.

Follow up:

This leads to another line of thought: if I can make something synthetically, might I be able to buy the real one, simultaneously sell the synthetic one for a higher price, and make a profit? Or the other way around – sell the real one and simultaneously buy the synthetic one for less? The answer, as for so many questions in options, is – yes and no. But investigating this does tell us some things we need to understand to trade options profitably.

The “Yes” part of the answer is yes, we certainly can create a position that includes an actual long (something) together with a synthetic short version of that same (something). For (something) in the preceding sentence you can substitute (stock), (call), or (put).

The “No” part of the answer is that in modern liquid markets, opportunities to do this are few and far between. Otherwise, we’d have the equivalent of being able to buy ten dimes for 95 pennies. Nice work if you can get it, but what do you do when your little brother runs out of dimes? There used to be lots of “little brothers” in the options market, but most of them have gone on to careers in the humanities or other low-math fields.

However, understanding how such a thing might be done can help us. At the very least, it can help us avoid playing the role of the ill-informed little brother.

Let’s look at an example that includes an actual long stock, and a synthetic short stock. This position has a name: it’s called a Conversion. When done the other way around, with an actual short position in the underlying and a synthetic long position, it’s called a Reverse Conversion, or just a Reversal. Both Conversions and Reversals are categorized as Arbitrage trades, as opposed to Directional trades or Volatility trades. They make money from mis-pricing of one of their components compared to the others. Neither underlying price nor volatility makes any difference. In practice, these trades are usually only done by option market makers, where the small profit per contract is made practical by small trading costs and the ability to trade many contracts at once.

We’ll use QQQ as of April 4 for our example. Here are some relevant figures:

As described in the earlier articles, we could create a synthetic short stock position, by buying a put option and also selling a call option, that share the same strike price.

In this case, we could create a synthetic short stock position by buying the May 69 Put for $ 1.60 and selling the May 69 Call for $.99. This would be a net of (1.60 – .99) = $.61 out of pocket. This difference between the call price and the put price is called the conversion/reversal price or conversion/reversal market. It should be about equal to the difference between the current underlying price and the option strike price. In this case that would be the difference between $68.43 and $69.00, which is $.57.

If in addition to our synthetic short position, we created a Conversion by also buying the QQQ at the closing price of $68.43, we would in effect be long at $68.43 and short at $69.00. The difference is (69.00 – 68.43) = $.57. That is what the entire position will be worth at expiration at any price of the underlying. We can see that by looking at a few sample prices. The following table shows the results for a few different QQQ prices at option expiration. For each QQQ price, we can see what the gain or loss would be on the conversion position and for each of its components – the long stock, the short call, and the long put:

Click to enlarge

Great. So we have a position where we are guaranteed a loss of 4 cents no matter what. That’s two minutes of your life reading up to this point down the tubes, right?

Well, maybe not.

For one thing, as owners of the ETF, we’ll collect one of QQQ’s monthly $.05 dividends. And we don’t have to pay that right back out as we would if we had an actual short QQQ position. Synthetic stock positions don’t collect or pay dividends – only real ones do. The lesson on this point is that when looking at any positions involving the underlying, we have to take dividends into account. In the case of the Conversion they help us. In the case of a Reversal, they hurt us (since we have to pay out the dividends when we are short the stock). Little brothers looking for Reversals sometimes neglect this.

In this case the 5-cent dividend puts us a penny to the good, ignoring commissions. Better, but still not worth getting out of bed for, so far.

Next, if we could have bought the stock or the put just a little cheaper, or sold the call for a little more, that guaranteed 1-cent profit could have been a bigger number. And that’s the way conversions can make money. If we find a situation where the option pricing is out of whack for some reason, so that the conversion/reversal market is cheaper or more expensive than it should be, then we can jump on it and lock in a profit. This will not happen often, but it’s worth knowing about.

The real value in knowing how Conversions and Reversals work is another step in your understanding of the options market. Being able to quickly recognize what a position does, along with its variants and synthetic equivalents, will help you to uncover opportunities that the little brothers miss.


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