Q&A
Got a question about options? Tom Gentile is the chief options strategist at Optionetics (www.optionetics.com), an education and publishing firm dedicated to teaching investors how to minimize their risk while maximizing profits using options. To submit a question, post it on the Stocks & Commodities website Message-Boards. Answers will be posted there, and selected questions will appear in future issues of S&C. Contributing analysis is by senior Optionetics strategist Chris Tyler.
CONVERTING PROFITS?
I’ve heard professional option traders use a spread called a “conversion” to establish risk-free positions. Is this true? And if so, why don’t we hear more about these strategies, or is this something the larger players don’t want us to know about?
While there may be some situations out there that merit consideration, the establishment of conversions, or the other side of the trade, the reversal, aren’t prime suspects. These spreads aren’t risk-free positions, as much as they are nondirectional arbitrage strategies.
With a conversion or reversal, synthetic stock is built using same-month, same-strike calls and puts that are executed as a hedge against a stock position of the same ratio size. In the case of the conversion, the trader has bought a 1-to-1 ratio of long stock and synthetic short stock using a short call and long put. To establish the reversal, the position would maintain short stock, a short put, and long call.
When executing a package involving all three legs, traders are generally looking to have long stock inventory on hand or possibly making a play on a dividend increase or decrease. A third motive is the trader taking the other side of the customer order flow as it maintains the side with “edge.” That said, the edge isn’t the type of pricing the layman could appreciate as a secret source of untold trading fortunes.
The reality is that these positions boil down to who has the best margin treatment, commission schedules, and interest rates. The ultracompetitive nature of those constraints means profits are calculated down to a fraction of a cent in some instances and only make sense to the largest of players.
Now, regarding the first choice of putting up a conversion for long stock inventory. This can be a necessary cost of doing business for market makers; so much so, they’ll actually forfeit edge in order to have the desired position. This is common when traders are active in an equity in which hedging with short stock poses additional risks due to liquidity and/or short interest. With its long stock in inventory, the conversion allows future hedging of long deltas incurred during the course of business, without the restrictions or hazards often faced by traders attempting to short stock as a hedge.
ODDLY CORRECT
Could you explain how a calendar is priced when the purchase of additional back-month contracts is involved? I understand how the bid/ask are quoted for a regular 1-to-1 spread, but I’m confused by this type of market’s pricing when there’s a ratio between the purchased and sold contracts.
It sounds as though you’re at odds with the pricing of this more complex spread market, which is understandable given it deviates from the normal pricing we’re used to seeing. We also think once you know the mechanics behind this type of packaged spread, you’ll agree it makes sense. Let’s break down this process by first beginning with a normal calendar market for a trader wishing to execute five spreads off the quoted markets shown below:
July 20 call: $0.80 B // $0.90 A August 20 call: $1.10 B // $1.20 A
Splitting both individual markets, the trader is presented with a midmarket spread value of $0.30 using $1.15 for the August contract and $0.85 for July. The two-sided quoted market is $0.20 bid, if you wanted to sell the calendar. At the same time, it’s offered at $0.40 if you wanted to get long the spread by taking the offer and hitting the bid. Remember, though, these prices are per contract. Thus, while you might wish to pay a midmarket price of $0.30, since you’re looking to buy five calendars, if executed, the associated debit is $150.
Easy, right? Now, let’s say the trader wishes to mix it up as you’ve presented and put together a ratio calendar where fewer short contracts are sold. The trader likes the idea of collecting some premium in the event the stock winds up sitting near the 20 strike but wants to maintain upside potential in case a quicker than expected upswing occurs.
Say the trader decides to purchase five August 20 calls but will now only sell four of the July 20 calls. Net, net the trader is long one call contract. This will benefit the trader if XYZ were to move up, but at the same time, the four short contracts will reduce the net debit and benefit the position if shares remain near the strike.
Once he or she is ready to execute this position, the trader puts in the contract amounts of +5 and -4 into the order entry platform at their online brokerage. Lo and behold, the following market greets the trader: $1.90 B // $2.80 A. The ratio calendar spread is priced to reflect the dollar cost of the four straight calendars plus the cost of one additional August 20 call.
Here’s how it works. Again, using our midmarket prices of $1.15 and $0.85, the trader has four straight calendar spreads priced for $0.30 per contract. That translates into a grand total of $1.20, as the cost would be a debit of $120. At that point, the trader adds the extra fifth contract priced (still) at $1.15 to the straight calendar price of $1.20. The combined sum gives the trader a price of $2.35 or $235, which happens to be in the middle of our not-so-odd looking quoted market.