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"What's Your Single Biggest Question About Options
Trading?"
Question:
"Could you please
explain more on "locked" option trades such as conversions,
reversals and box spreads? Did you use the same terms as McMillan?
"
- George
(Asked March 26, 2006 - 9:53 AM)
Answer:
"Hi George,
A locked trade is one that (theoretically) has
no risk. In other words, the profit or loss is “locked” in place and
cannot change regardless of what happens to the underlying stock.
A conversion consists of three pieces: Long stock, long put,
and a short call with all of the options executed at the same strike
price. For example, you may buy stock at $50, buy a $50 put, and
sell a $50 call, which puts you into a conversion. To understand why
this is a locked trade, let’s look at the call and put options by
themselves. Notice that you are long the put and short the call,
which you may realize is the same thing as a synthetic short stock
position. If you’re not familiar with synthetic positions, they are
just combinations of stock, calls, and puts that are combined in
ways to behave like other assets. If you were to plot the profit and
loss diagram for the long put and short call, you’d find that it is
exactly the same as a short stock position. In the conversion, that
synthetic short stock position is paired with a long stock position,
which means the position is basically closed. It’s as if you were
long and short the same stock so all profit or losses are locked in
place.
A reversal is just the reverse of a conversion and is
consequently referred to as a “reverse conversion” as well. It is
made up of short stock, short put, and a long call. Synthetically,
it is the same thing as a short stock plus long stock position,
which means it is locked just like the conversion.
In most
cases, professional traders do not put on all three sides of the
conversion or reversal at the same time. Instead, they buy one or
two of the “legs” and then use the third to lock in profits more
efficiently.
There is another way we can understand why
conversions and reversals are locked trades. If you run a
Black-Scholes Model, you will find that the at-the-money call will
be priced higher than the at-the-money put by the cost of carry on
the strike price. In other words, if you buy a $50 call, for
example, you do not pay for the stock today. Instead, you can delay
your purchase until expiration thus hanging onto the strike price
and earn interest. The at-the-money call is priced higher than the
at-the-money put by this interest amount. If you sell the call and
buy the put, you will therefore collect the net difference, which is
effectively just the interest on the strike price. If you then
purchase the stock you have completed the conversion and have a
trade that can only earn the interest amount of the strike price. We
know from basic properties of finance that any risk-free asset
should return the risk-free rate of interest and that’s exactly what
this conversion is going to deliver to you, which means it must be
risk free. In other words, it is locked.
A box spread is
similar in nature to the conversions and reversals. A box spread is
simply a conversion at one strike and a conversion in another. The
long and short stock positions cancel each other out and you’re left
with a synthetic long position matched with a synthetic short
position, which means the position is again locked.
The
terms conversion, reversal, and box spreads are all industry
standard terms so are the same as those referred to by McMillan.
"
- Ron
Ianieri
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