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+Chapter 27: Arbitrage 429 
+until expiration. The inclusion of these factors complicates things somewhat, and its 
+discussion is deferred momentarily while the companion strategy, the reversal, is 
+explained. 
+A reversal (or reverse conversion, as it is sometimes called) is exactly the oppo­
+site of a conversion. In a reversal, the trader sells stock short, sells a put, and buys a 
+call. Again, the put and call have the same terms. A reversal will be profitable if the 
+initial credit ( sale price) is greater than the striking price of the options. 
+Example: A different set of prices will be used to describe a reversal: 
+XYZ common, 55; 
+XYZ January 60 call, 2; and 
+XYZ January 60 put, 7½. 
+The total credit of the reversal is 60½ - 55 from the stock sale, plus 7½ from the put 
+sale, less the 2-point cost of the call. Since 60½ is greater than the striking price of 
+the options, 60, there is a locked-in profit equal to the differential of½ point. To ver­
+ify this, first assume that XYZ is anywhere below 60 at January expiration. The put 
+will be assigned - stock is bought at 60 - and the call will expire worthless. Thus, the 
+reversal position is liquidated for a cost of 60. A ½-point profit results since the orig­
+inal sale value ( credit) of the position was 60½. On the other hand, if XYZ were above 
+60 at expiration, the trader would exercise his call, thus buying stock at 60, and the 
+put would expire worthless. Again, he would liquidate the position at a cost of 60 and 
+would make a ½-point profit. 
+Dividends and carrying costs are important in reversals, too; these factors are 
+addressed here. The conversion involves buying stock, and the trader will thus 
+receive any dividends paid by the stock during the life of the arbitrage. However, the 
+converter also has to pay out a rather large sum of money to set up his arbitrage, and 
+must therefore deduct the cost of carrying the position from his potential profits. In 
+the example above, the conversion position cost 49½ points to establish. If the trad­
+er's cost of money were 6% annually, he would thus lose .06/12 x 49½, or .2475 point 
+per month for each month that he holds the position. This is nearly ¼ of a point per 
+month. Recall that the potential profit in the example is ½ point, so that if one held 
+the position for more than two months, his carrying costs would wipe out his profit. 
+It is extremely important that the arbitrageur compute his carrying costs accurately 
+prior to establishing any conversion arbitrage. 
+If one prefers formulae, the profit potentials of a conversion or a reversal can 
+be stated as: