A conversions question.

[raf_bcn]

Hi

A conversion, long stock and short synthetic stock, it is a debit strategy.
I am confused about a coupple of things, margin requirement and the impact that the strategy has in the Equity with loan.
E.g. A conversion in Xle for which I pay 72.00
_ My Equity with loan increases , what is the reason ?

_ The initial margin required by the broker is 2,200.00 and the maintenance margin is 1,100.00 But, why is the margin so high, What are the real risks for that strategy ?
It seems a strategy with no risk. I don't understand why that margin.

thanks.

 

[spindr0]

My recollection is that the initial margin requirement for a conversion is 50% of the stock's cost + the cost of the put option and no requirement on the short call.

Google "CBOE Margin Manual" for exact details. Brokers have the right to require more margin than Reg T. As for your broker's numbers, I have no clue.

 

[ET180]

Hi

A conversion, long stock and short synthetic stock, it is a debit strategy.
I am confused about a coupple of things, margin requirement and the impact that the strategy has in the Equity with loan.
E.g. A conversion in Xle for which I pay 72.00
_ My Equity with loan increases , what is the reason ?

_ The initial margin required by the broker is 2,200.00 and the maintenance margin is 1,100.00 But, why is the margin so high, What are the real risks for that strategy ?
It seems a strategy with no risk. I don't understand why that margin.

thanks.

I haven't personally traded this strategy yet, but from what I remember, it's basically a way to get an almost guaranteed fixed rate of return from capturing the base interest rate. The benefit is that you'll get a slightly better rate of return than the best bank CD or money market account, but it will tie up capital while the trade is on (you'll have to hold the stock). Also, depending on the value of the call when a dividend is issued, it might make sense for the holder of the long call to exercise the call in which case the stock will be sold at the call's strike and you won't capture the dividend and will be left with the long put (which can be sold to close out the trade).

 

[FSU]

Risks of a conversion are,
If there is a dividend, it is reduced,
Upward change in the interest rate,
If the stock is hard to borrow, you "lose" the
hard to borrow value over time,
Pin risk (you hold to expiration and the stock settles
around the strike price so you are not sure if you will
be assigned on your short call)

Rewards of conversion,
Dividend increase,
Downward change of interest rate,
If the stock becomes hard to borrow, the conversion
will be worth more.

 

[raf_bcn]

Yes now I realize it has to be some margin since I buy the stock on margin. So at least the amount that I pay becomes margin.
I use to do credit strategies where the margin is the maxim risk.

Risks of a conversion are,
If there is a dividend, it is reduced,
Upward change in the interest rate,
If the stock is hard to borrow, you "lose" the
hard to borrow value over time,
Pin risk

An upward change in the interest rate will traduce in an oportunity cost, but I don't se how can affect the existing position.
If it is a winning position, i.e you pay less for the conversion than the strike of the call and put, it will continue to be.

thanks.

 

[FSU]

An upward change in the interest rate will traduce in an oportunity cost, but I don't se how can affect the existing position.

The conversion price is based on the cost of carry of the position and dividends received. If interest rates go up, the cost of carry will increase and the conversion will decrease in total price, as it will now cost the buyer more to hold the position. Your existing position will be worth less as interest rates increase.

You could make the argument that it would have to be an unexpected rate increase. If the increase is expected it may be written into the price.

 

[ET180]

The conversion price is based on the cost of carry of the position and dividends received. If interest rates go up, the cost of carry will increase and the conversion will decrease in total price, as it will now cost the buyer more to hold the position. Your existing position will be worth less as interest rates increase.

You could make the argument that it would have to be an unexpected rate increase. If the increase is expected it may be written into the price.

That's true, but if one holds the position until the options expire, then I don't think one will lose money because they would have bought the underlying for less than the strike price of the short call and long put. So the holder is guaranteed to make money on the eventual sale of the stock. However, that fixed return may turn out to less than the yield on an alternative risk-free return that they could get at time of sale.

 

[FSU]

That's true, but if one holds the position until the options expire, then I don't think one will lose money because they would have bought the underlying for less than the strike price of the short call and long put. So the holder is guaranteed to make money on the eventual sale of the stock. However, that fixed return may turn out to less than the yield on an alternative risk-free return that they could get at time of sale.

Its similar to buying a bond. You still get the same interest that you thought you would, even if interest rates change. The bond is just worth less if interest rates increase.