What is Reverse arbitrage?
1 Replies
Balaji R K
(Salaried)
(158 Points)
Replied 15 July 2009
Arbitrage
The simultaneous purchase and sale of an asset in order to profit from a difference in the price. It is a trade that profits by exploiting price differences of identical or similar financial instruments, on different markets or in different forms. Arbitrage exists as a result of market inefficiencies; it provides a mechanism to ensure prices do not deviate substantially from fair value for long periods of time
Conversion Arbitrage or Rever Arbitrage
An options trading strategy employed to exploit the inefficiencies that exist in the pricing of options. Conversion arbitrage is a risk-neutral strategy, whereby the trader buys a put and writes a covered call (on a stock that the trader already owns) with identical strike prices and expiration dates. A trader will profit through a conversion arbitrage strategy when the call option is overpriced.
Eg:
If the price of the underlying security falls, the put purchased increases in value by the same amount as the loss incurred by writing the call. If the underlying security's price increases, both the put and the call expire worthless. In both situations, the trader is risk neutral, but profits from the difference between the price at which the call was sold and the put was purchased.
As with all arbitrage opportunities, conversion arbitrage is rarely available. This is because any opportunity for risk-free money is acted on quickly by those who can spot these opportunities quickly.
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