V. 21:1 (36): Q&A by Don Bright

Q&A by Don Bright

CONVERSIONS

I’m new to options trading. Would you explain what a conversion is? — Kelly, Cincinnati

“Conversion” means the buying of puts and selling of calls at the same price, and also buying the underlying stock at the same time. Conversions are critical to valuations, because although calls or puts may look overvalued based on historical volatility, interest rates, and so on (option modeling), they probably aren’t when compared to the full “three-way.” If you look at the call, put, and stock, you will find that the net pricing will be near fair value (again, based on interest rates, days until expiration, dividends, and so on). On the trading floor, traders will use the three-way valuation as a way to hedge themselves. For example: if I end up selling 200 calls at a good high price to the public, I can either buy other calls to hedge, sell puts, or buy stock, in order to get “delta-neutral.” If I end up with too much gamma (short-term delta movement), I can compensate by completing a three-way to level out (again, just locking in profits from the call sales by being able to then turn around, buy the calls back, sell the puts, and sell the stock at fair value).