Risk in holding conversions/reversals to expiration?

Don Bright · Feb 16, 2012

Quote from atticus:

Sorry, I assume they are. I forgot to add that I did one conversion in ZN years ago that had some wild-marks. In shares they use midpoint, so I assume they derive the mark from spot and either one of the call or put.

Leaving a lot of capital in cash negates the purpose.

Hey Atticus, how are things? Glad to see you're keeping the people informed here, good job as always.

Don

jones247 · Feb 16, 2012

I come across many conversion & reversal opportunities; however, the problem (as Don stated) is that there are merely pennies available. When you calculate the cost of the trade (i.e. portfolio margin rate + commissions) for the sheer volume needed to make the trade worthwhile, then the pennies of arbitrage opportunity are eaten up... NO FREE LUNCH (aaarrrrgh)!!

Walt

Quote from Don Bright:

Conversions and reversals are in wide-spread use today, as they were back in the "good old days."

Traders tend to put on positions, calendars, money spreads, all the same old stuff we did back then (we did all that stuff for quarters, even dollars, now days, more like pennies)... regardless, traders use the synthetics to get out of their positions, at pure fair value. Banks and other institutions use them to establish a position that might be otherwise hard to do (naked buying of stock for example). Simple games, simple responses.

edit: back to topic, yes the risk is have the closing price right at or very near the strike price. I remember having to try to buy enough stock to hopefully have the price move above the strike (don't try that these days, LOL).

Don

TraDaToR · Feb 17, 2012

Exactly. Arbitrage opportunities are available, not only in options, but also in calendar spreads when there is no implied functionality or on contracts listed on several exchanges.

If you run a scanner everyday, you will sure have some arbs available( manually in fact ), but the risk is high. Ex: For this conversion, I have a 5 ticks edge per conversion. 5 ticks is nothing on this contract if there is pinning and I end up without the offseting futures... Also when you try to do arbs, you often end up with illiquid instruments where it is hard to get in/out and there can be some unknown rules affecting the contract that will neglect your edge.

I have been doing pure arbs for 5 years but I think the most I made out of it was like 7K$ one year, so it really is a marginal revenue generator.

Once I did a 1K$ per contract arb though...

lightrader · Feb 17, 2012

Quote from Don Bright:

Conversions and reversals are in wide-spread use today, as they were back in the "good old days."

Traders tend to put on positions, calendars, money spreads, all the same old stuff we did back then (we did all that stuff for quarters, even dollars, now days, more like pennies)... regardless, traders use the synthetics to get out of their positions, at pure fair value. Banks and other institutions use them to establish a position that might be otherwise hard to do (naked buying of stock for example). Simple games, simple responses.

edit: back to topic, yes the risk is have the closing price right at or very near the strike price. I remember having to try to buy enough stock to hopefully have the price move above the strike (don't try that these days, LOL).

Don

When you said that conversions/reversals are also widespread today, do you mean that traders are trading conversions/reversals by using spread orders (so that all of the legs are filled or none of them is filled, without any execution risk)? Or basically trading conversions as arbitrage opportunities (as opposed to get out of positions) means legging into the conversion/reversal and therefore having a substantial execution risk? Thanks in advance for any clarifications, from you or other readers.

rmorse · Feb 17, 2012

Quote from lightrader:

When you said that conversions/reversals are also widespread today, do you mean that traders are trading conversions/reversals by using spread orders (so that all of the legs are filled or none of them is filled, without any execution risk)? Or basically trading conversions as arbitrage opportunities (as opposed to get out of positions) means legging into the conversion/reversal and therefore having a substantial execution risk? Thanks in advance for any clarifications, from you or other readers.

Options Market Makers are except from locates. That means they can sell stock short, in hard to borrow securities when others can't. For hedge funds or non broker dealers that are not except, that want to be short these securities for whatever reason, they can and do offer long stock for a fee through a conversion.

Don Bright · Feb 17, 2012

Quote from lightrader:

When you said that conversions/reversals are also widespread today, do you mean that traders are trading conversions/reversals by using spread orders (so that all of the legs are filled or none of them is filled, without any execution risk)? Or basically trading conversions as arbitrage opportunities (as opposed to get out of positions) means legging into the conversion/reversal and therefore having a substantial execution risk? Thanks in advance for any clarifications, from you or other readers.

Most option traders, on the floor and upstairs, look for nothing more than simple volatility variances. They will buy and sell calls and puts of various strikes and expirations, and then they will review their positions, categorize into long spreads, short spreads, straddles, strangles, all the basic stuff, and when reducing positions, they know they can to the 3way with a bank or institution to close out when appropriate.

Don

FSU · Feb 17, 2012

Quote from rmorse:

Options Market Makers are except from locates. That means they can sell stock short, in hard to borrow securities when others can't.

Dont think that is true Bob. If that was the case the MM would just load up on reversals and pocket the hard to borrow premium.

lightrader · Feb 17, 2012

Quote from Don Bright:

Most option traders, on the floor and upstairs, look for nothing more than simple volatility variances. They will buy and sell calls and puts of various strikes and expirations, and then they will review their positions, categorize into long spreads, short spreads, straddles, strangles, all the basic stuff, and when reducing positions, they know they can to the 3way with a bank or institution to close out when appropriate.

Don

So that means that they use conversion/reversal mainly for closing positions, not as pure arb opportunities?

Also, is it possible to enter into arb opportunities such as boxes/conversions/reversals by using spread orders to eliminate execution risk (especially when implied pricing functionality exists) or it is not possible?

Don Bright · Feb 17, 2012

Quote from lightrader:

So that means that they use conversion/reversal mainly for closing positions, not as pure arb opportunities?

Also, is it possible to enter into arb opportunities such as boxes/conversions/reversals by using spread orders to eliminate execution risk (especially when implied pricing functionality exists) or it is not possible?

What happens is the banks and other institutions who have a reason for wanting either long or short stock positions will "quote" (ask for quotes) a certain box or conversion, whatever. The MM's will decide among themselves a good price to do maybe 1,000 or more contracts, and "get into" a position with a slight edge. OR - they will do as I said above, and use the more "risk adverse" method to close out. Been that way since I was on the floor. A lot has changed, but as they say, "the more things change the more they remain the same."

Have a great long weekend, I'm off to the Venetian for a poker tournament....

Don

Risk in holding conversions/reversals to expiration?

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