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Conversion arbitrage is an investment strategy that essentially involves three specific actions that take place at the same time. The execution of this type of arbitrage approach is understood to be relatively risk free for the investor, while still having the ability to strengthen the investing position as it relates to the overall stability of the investment portfolio. Sometimes referred to as a long option box, the conversion arbitrage will always involve elements that carry the same expiration date and exercise price.
The three transactions that make up a conversion arbitrage are very simple. The first transaction involves the purchase of an asset. This stock transaction is sometimes referred to as acquisition of the underlying, and forms the foundation for the process.
Occurring simultaneously with the purchase of the underlying asset is the purchase of a put option. This put option will have the same exercise prices and the same expiry date as the underlying asset. It is essential that the price and expiration date be identical in order for the strategy to work.
The final element in the conversion arbitrage is the sell of a call option. Like the underlying asset and the put option, the call option must carry the same expiration date and the same exercise price. The sell of the call option must happen at the same time as the purchase of the put option and the acquisition of the underlying asset.
In some variations of the conversion arbitrage approach, the actual purchase of the underlying asset is replaced with the purchase of futures on an underlying asset. However, there is some difference of opinion among financial analysts as to whether the use of futures in the structure of a conversion arbitrage is more or less helpful than shares of stock to the overall strategy.
In general, the use of a conversion arbitrage is not intended as a means of making a huge and quick return. However, the strategy can generate some quick profit depending on the current status of the money market. At the same time, if market factors quickly cause the put and call to be overvalued or undervalued for some reason, this may lead to a situation where a small loss or profit results in the short term.
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