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A reverse conversion, or reversal, is an arbitrage technique sometimes employed when options are underpriced relative to the underlying stock. Arbitrage is the simultaneous purchase and sale of an asset to take advantage of a temporary price difference. The disparity in this case might be when a future option to buy is less than the option to sell. A brokerage firm might use a reverse conversion to earn interest on stocks they hold for investors. An individual investor might use the technique to invest assets advanced by a brokerage with the intent to quickly profit from a perceived option pricing discrepancy.
In financial terms, the investor will be short selling the underlying stock, then buying a call option and selling a put option with the same expiration date. Short selling the underlying stock means that it is sold with the intention of buying it back, usually at a more favorable price. To cover the risk involved, the investor buys a call option, which gives him the right buy a certain amount of the stock at an agreed upon price, known as the strike price, by the expiration date. Simultaneously, he sells a put option, which is the right to sell a certain amount of the stock at a given strike price by the expiration date.
Were an investor to conclude that options for a stock were undervalued he might try a reverse conversion. Typically, the investor is advanced assets by a brokerage firm and they are expected to replaced in kind. Underlying stocks would be sold short while simultaneously buying a call option and selling a put option.
If the options were undervalued, the call option would give him the right to buy back the stock for less than amount earned when selling short. The profit would be greater if the stocks had risen in value. In the case of a decline in stock value, the put option could be sold and the proceeds used to buy back the stock.
A brokerage may use a reverse conversion to earn interest on holdings. The firm would short sell assets in their customer's margin accounts and invest the proceeds in the short-term money market. Call and put options will likewise be simultaneously bought and sold, but with the same strike price and expiration date. This effectively hedges the investment by offsetting short-term market changes for the underlying stock. The reverse conversion is unwound by selling the call option, buying the put option and buying back the underlying stock.