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: