Conversions | |||||||
Recall the discussion in section Chapter 3. There is a theoretically equivalent position to holding a stock, a put or a call.
A conversion is the simultaneous trading of both a position and its synthetic equivalent, on opposite sides, to reap a profit from differences in the position prices. The market is constantly monitored electronically for these types of arbitrage positions and these positions are traded to parity immediately by professional traders. As a result, profitable conversion trades are practically impossible to execute off the floor. The result of constant market monitoring and conversion trading is a balanced market. A conversion can be used to lock in a profit on a position, while deferring the capital gain. A trader with a profitable portfolio may want to lock in a gain without selling the stock. The sale of the call and purchase of a put can lock in the profit or loss and defer the realization of the profit or loss until the expiration of the option. Conversions can also be used to realize dividends without risk, which can also defer income as well as generate income in a different tax bracket. |