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