In stock market, option is a contract between the buyer and seller of the stock. This contract contains the agreement about the right of the buyer and the obligation of the seller. The buyer right is that he/she has the right to buy the stock at the price that had been agreed by the seller. The seller obligation is that he/she has to sell the stock to the buyer at the price that had been agreed by the buyer. Option in stock market is just a contract between stock buyer and seller about the transaction stock price within a specified period of time. Option can be used to hedge portfolio or protect position just like how the insurance does to the property. Option can be used to protect your money that has been invested in the stock market. Besides stock protection, by utilizing option, we can carry out arbitrage strategy, which can earn profit no matter the stock price is going up, down or side way. Arbitrage strategy is a risk-free strategy and it can let you earn profit without incur any loss.
Conversion is one of the arbitrage types option trading strategy. This strategy involves buying stock, selling call option and buying put option. These three steps are carried out simultaneously. Call and put option strike price has to be the same and the amount of the money that has been received from selling call option must be enough to buy the put option. So, in this strategy, it seem like you just buy a stock only because the amount money that has received after selling call option is more than enough to buy the put option and usually, it has extra more remaining after selling call option and buying put option. The requirement for this strategy is that the difference between call option bid price and put option ask price has to be less than the difference between current stock ask price and the option strike price. The equation that represents the requirement is as follow:
call option bid price – put option ask price > current stock ask price option strike price
There are three ways for us to place order for this strategy. We can use collar strategy, covered call strategy by triggering one put option and combo strategy by triggering one stock. All the orders must be placed using limit. After executing this option trading strategy, what we need to do is just left these positions until expiration date. You can close all these three positions one or two days before the expiration date of the option by buying and selling to close or exercising the options.
As an example, we sell CAT company 60 may call option at USD 4.90 and we buy 60 may put option at USD 3.10 and also buy the CAT company stock at USD 61.35. The difference between the call and put option price is 4.90 3.10 = 1.80. The difference between the stock price and the option strike price is 61.35 60 = 1.35. So, the difference between the call and put option price is more than the difference between the stock price and the option strike price. The net of both differences is our profit that is 1.80 – 1.35 = 0.45. If we buy one contract, our profit is 0.45 x 100 unit = USD 45. However, the commission of the transactions for this strategy is usually USD 90, depending to which broker firm service we are using. So, we need to buy at least three contracts in order that we can earn a profit.
So, how actually this strategy works? When we buy put option, we actually protect the stock that we have bought. The purpose of selling call option is to generate money to buy put option. Seem like after selling call option and buying put option, it has extra money in the account. But, actually, we still need an amount of deposit to execute this strategy. So, after executing this strategy, if the stock price drops, we have put option protecting our stock. If the stock price really has dropped on the expiration date, we can sell or exercise the put option to recover all the loss from buying stock. If the stock price has gone up on the expiration date, we just leave both call and put option expire worthless. However, because we sell call option at 60 strike price, the buyer of the 60 may call option will come to us and ask for a stock at USD 60, even though current stock price is higher than this price. Because we sell call option at 60 strike price, we have the obligation to sell the stock to this buyer at USD 60. If we do not own any stock, we have to buy stock from the market at higher price and then sell it to the 60 may option buyer. This will cause us lost money. However, don’t worry, because we own stock, so what we need to do is that we just sell the stock at USD 60 to the 60 call option buyer. Even though the current stock price is higher, we do not lose anything from this strategy. Moreover, we still earn a small amount of profit. Why this can happen is due to the discrepancy of the stock and option price. This is because stock and option price are affected by their own supply and demand. That means the stock may have more demand but its option may have less demand.
The advantage of this option and stock trading strategy is that it is totally risk free. No matter how the stock price changes, the profit is fixed. It won’t go away. The second advantage of this strategy is that it can be multiplied by buying more contracts. If we accidentally see a penny on the road side, that all we have if we pick it up and keep it. But in stock market, when we see this discrepancy, we can multiply this small amount by buying more unit of stock. However, there are actually got a lot of disadvantages in this strategy. The first disadvantage is that the profit is very little, usually 10 to 50 cent per unit option. The second disadvantage is that only high-price stocks have this opportunity. The third disadvantage is that the commission to execute this strategy is high, usually is USD 90 for the whole transaction. However, this disadvantage can be overcome by using the broker firm that charges less commission. The fourth disadvantage is that huge capital is needed to execute this strategy. This is because a few contracts of high-price stock have to be bought in this strategy.