Conversions and Reversals
When calls and puts are combined to create synthetic stock, the main
differences are the interest rate and dividends. This is important because the
risks associated with interest and dividends can be isolated, and ultimately
traded, when synthetic stock is combined with the underlying. There are
two ways to combine synthetic stock with its underlying security: a
conversion and a reversal.
Conversion
A conversion is a three-legged position in which a trader is long stock, short
a call, and long a put. The options share the same month and strike price.
By most metrics, this is a very flat position. A trader with a conversion is
long the stock and, at the same time, synthetically short the same stock.
Consider this from the perspective of delta. In a conversion, the trader is
long 1.00 deltas (the long stock) and short very close to 1.00 deltas (the
synthetic short stock). Conversions have net flat deltas.
The following is a simple example of a typical conversion and the
corresponding deltas of each component.
Short one 35-strike call:−0.63 delta
Long one 35-strike put:−0.37 delta
Long 100 shares: 1.00 delta
0.00 delta
The short call contributes a negative delta to the position, in this case,
−0.63. The long put also contributes a negative delta, −0.37. The combined
delta of the synthetic stock is −1.00 in this example, which is like being
short 100 shares of stock. When the third leg of the spread is added, the
long 100 shares, it counterbalances the synthetic. The total delta for the
conversion is zero.
Most of the conversion’s other greeks are pretty flat as well. Gamma,
theta, and vega are similar for the call and the put in the conversion,
because they have the same expiration month and strike price. Because the
trader is selling one option and buying another—a call and a put,
respectively—with the same month and strike, the greeks come very close