Reversals

Reversals are primarily a Floor Trader strategy used to capitalize on minor price discrepancies between calls and puts. As implied by its name, reversals are the exact opposites of conversions. Reversals involve buying something in one market and simultaneously selling it in another to take advantage of whatever small difference exists. Reversals are usually done when options are comparatively under priced. To put on the position, the trader sells stock on the open market and buys the options corresponding in the option market. When options are moderately overpriced, traders then do conversions. In theory, conversions and reversals are associated with low risk because the profit is locked in almost instantaneously. Therefore traders do conversions and reversals as often as the market will allow.

The point of a reversal is to create a synthetic long position and offset it with a short position in the same principal stock. The synthetic long position is created by buying a call and selling a put with the same strike price and expiration. The combining of a synthetic long position with a short stock position creates a reversal.

For example: If a stock is trading for $104, the 100 calls/100 puts should equal $4. At these prices the calls and puts are relatively under-priced, with the stock at $104 because the synthetic long position (long call and short put) can be purchased for 3.90. Hence, by selling the stock at $104, buying the call for 7.50 (the offer) and selling the put for 3.60 (the bid), the trader locks in a .1 point profit.

Individual investors and other off-the-floor traders seldom have the opportunity to do conversions and reversals because price differences in general only exist for a matter of moments. Professional option traders are constantly on guard for these opportunities. As a result, the market quickly balances itself.