Reversal Conversion. So What !/?

Discussion in 'Trading' started by minorearth, May 17, 2011.

  1. With XYZ around $20.00, a hundred shares are sold for $20.00, one July 15 ITM Call is purchased for $6, and one July 15 OTM put is sold for $2.00. This reverse conversion position would begin with a $1.00 credit.

    Looking over the risks, early assignment seems to be the most emphasized among trading authors.

    With July options expiration date in a few days, and the above scenario being true, lets say prices go down from $20.00 to $10.00. Lets now assume the July 15 OTM put sold for $2.00 is exercised by the purchaser, closing out our 100 share short position. A $2.00 profit would be received from the exercised short, and the long July 15 call loss would be covered by the 100 shares we shorted from $20.00

    Shouldn't a $1.00 profit be guarenteed regardless of future movement up until July's option expiration date.

    There isn't going to be a margin call, and, we could sell the long call if we choose.

    I'm not including the risk of the stock in question becoming unshortable in the middle of our trade.

    Would someone help me in understanding the risks involved I'm overlooking?
  2. spindr0


    Check what the borrow rate is for shorting the shares as well as if there's a large pending dividend.

    There are no free lunches.
  3. MTE


  4. Are those two concerns of yours the last risks you would consider?
  5. MTE


    Dividends and borrow rate are not risks, but two pieces of information you are most likely missing that make this look like free money to you!
  6. Just glancing through. Naked short call and covered put. Not risk free.
  7. MTE


    The OP is buying the call not selling it.
  8. If I am not mistaken:

    Your credit: $1 x 100 = $100

    Price goes from $20 to $10: you make $10 x 100 = $1,000

    July 15 OTM put is exercized: you lose $5 x 100 = -$500

    Net: $100 + $1,000 - $500 = $600

    Plus, you have to add interest paid on it and any dividends paid.

    Correction made to original calculation.
  9. MTE


    Your calculation is wrong.

    You make $1,000 on the short stock.

    You lose $600 on the long call that expires worthless.

    You lose $300 on the short put. The put expires 5 points ITM ($500), but your intial credit is $200, so net loss is $300.

    Overall: 1,000-600-300=100 profit, but most likely these 100 will be eaten by the borrowing rate on the short stock position and/or by the dividend.