A conversion or a reversal is an option combination that retail traders will execute very rarely as a package (meaning as a single trade) and professional market makers will execute only occasionally. But a conversion or reversal is an option combination that a smart retail trader might end up having on; however, it will only be because of separate trades that lead to the ultimate conversion or reversal position.
A conversion is a three-legged combination made up of a long position in the underlying stock and a synthetic short position in the stock made up of a long put and short call, both with the same strike price and expiration date.
- Long 100 shares of KO at 39.70
- Short 1 November 39 call at 0.95
- Long 1 November 39 put at 0.25
How does this conversion make money? We start with 0.70 in our pocket because we sold the 39 call at 0.95 but paid only 0.25 for the 39 put. The combination of the two option positions is a synthetic short position in KO stock. How so? Short a call and long a put with the same strike and expiration date will end up selling the stock—either the call will be assigned and we’ll sell the stock at the exercise price of 39.00, or we’ll exercise the put and sell the stock at the exercise price of the put; again that’s 39.00. For example, if KO is at 35.00 at expiration, below the strike price of our put, then the call would expire worthless and we would exercise our put, thereby selling our KO shares at 39.00. ...