A while back we published the article How do you find option arbitrage opportunities? Since then, we’ve received quite a few requests from users who found forward or reverse conversion trades that seemed too good to be true.
In this follow-up article, we’re going to go into a bit more detail about why conversion trades are used. However, our goal here is to better explain why they’re probably not a good fit for most scenarios.
It’s assumed that you already understand the structure of a conversion trade. For a forward conversion, you buy stock and then hedge it with a synthetic short position. A reverse conversion is the inverse trade. Either way, you end up with a trade that should produce a fixed return regardless of underlying price movement.
Let’s talk about the four scenarios where a conversion may be considered.
Scenario 1: Hedging an underlying position
A common use for conversions is to hedge an underlying position that the investor cannot close for some reason. To raise cash against the shares, they might sell a synthetic short against the holdings, resulting in a forward conversion. The cash raised from the option trade can then be used to diversify the portfolio through other investments. Note that the availability of this strategy depends on your margin requirements.
Scenario 2: Efficient pricing
In an efficient market, the return for a forward conversion should approximate the risk-free interest rate for that term. After everything else has been factored out, you’re effectively loaning the entry cost of the trade to the counterparty. This also means that the reverse conversion should return a loss around the risk-free interest rate because it’s basically a loan. In this properly-priced scenario, there’s really no reason to use a conversion. If you come across a scenario where a conversion offers a return better than the risk-free rate, then you need to dig deeper to find out why.
Scenario 3: Inadvertent option mispricing
The true arbitrage opportunity for conversions exists when a call and put at the same strike and expiration are relatively mispriced with no special circumstances (more on these later). However, that scenario really doesn’t exist for manual trading in modern times thanks to high-speed algorithmic trading. If you come across a situation where the rate of return is better than the risk-free rate, assume it’s due to special circumstances and not due to mispriced options.
Scenario 4: Special circumstances
Sometimes the options market will produce a prospective conversion that offers an outsized return. When that happens, assume it’s because there are special circumstances. It’s critical that you understand what they are before entering the position.
Is the stock hard to borrow?
When a stock is hard to borrow, investors turn to buying puts and selling calls. This can result in significant credit being offered to those willing to enter a synthetic long position by buying calls and selling puts. This can really juice the projected returns of a reverse conversion. Unfortunately, since the trade requires a short stock position, you probably won’t be able to enter it due to the stock being unavailable to short. Or, if it is available, the cost of borrowing could be so significant that it consumes the profit.
Is there a dividend?
When a stock issues a dividend, it will already be factored into the option pricing. Holders of forward conversions will receive the dividend, whereas reverse conversion holders will owe the dividend. These payments must be factored into the final return (which Quantcha does for you).
When the projected return exceeds the risk-free rate, there are two reasons the dividend could be the reason.
First, the dividend data could be wrong. Unfortunately, it can be very difficult to source reliable dividend data, especially beyond the next expected dividend. Always check the projected dividend against other sources (or the company’s public reporting) to confirm accuracy.
Second, the market could be expecting a change in the upcoming dividend. If the market expects the dividend to decrease, the option pricing will adjust to meet the consensus. As a result, forward conversions using the current official dividend expectations will have higher profit projections (and vice versa).
As with most option trades, there is an opportunity to profit when you disagree with the market (and are ultimately correct, of course). For example, if you expect a dividend to increase before the market realizes it, you can use a forward conversion to isolate the opportunity.
Are interest rates changing?
Similar to dividends, the market may expect changes in the prevailing risk-free interest rates. Given that rates don’t generally make drastic moves overnight, these changes should have minimal impacts to the overall return profile.
Are conversions right for you?
While conversions can produce a profit opportunity under the right circumstances, they’re usually not an efficient play. If you’re looking for a risk-free return, then consider traditional vehicles like treasuries. Otherwise, be sure to do your due diligence before entering a trade that seems too good to be true.