Options Education Center

First, add 1 to the interest rate: 1 + 0.05 = 1.05

Raise this to the power of 0.25: 1.05^0.25 ≈ 1.0123

Divide $100 by this result: $100 / 1.0123 ≈ $98.77

So, the present value of receiving $100 in three months, given a 5% risk-free rate, is $98.77.

Potential opportunities often arise during periods of increased volatility when market makers may be less aggressive in maintaining tight spreads. During these times, the options market may temporarily become less efficient, creating the possibility for price discrepancies.

High volatility environment scenario

During periods of market stress, bid-ask spreads often widen, creating opportunities for options conversions. Consider a volatile stock during a market correction:

Normal conditions:

• Stock: $50.00
• 2-month 50-strike call: $2.50
• 2-month 50-strike put: $2.50
• Bid-ask spreads: $0.05

During volatility spike:

• Stock: $50.00 (but trading in wide range)
• 2-month 50-strike call: $3.50 (bid: $3.25, ask: $3.75)
• 2-month 50-strike put: $3.50 (bid: $3.25, ask: $3.75)
• Bid-ask spreads: $0.50

The wider spreads and increased uncertainty can lead to temporary imbalances of put-call parity, especially when market makers reduce their risk exposure.

Index option versus component stock inefficiencies

Sometimes, inefficiencies arise between index options and the underlying component stocks. For instance, during index rebalancing periods:

S&P 500 scenario:

• Index level: 4000
• Major component stock being removed
• Index options adjust quickly
• Component stock options adjust more slowly

This creates temporary imbalances between the fair values of index options and the aggregate values of component options, leading to conversion opportunities at index and individual stock levels.

Dividend announcements, merger proposals, and other corporate events can create temporary mispricing between options and the underlying stock. These situations may also provide opportunities for conversion strategies, particularly
when the market takes time to adjust to new information fully.

Dividend announcement scenario

Consider a stock trading at $75 with a surprise dividend announcement. The market might take time to fully adjust option prices to reflect this new information. For example, if a $1 special dividend is announced, we might temporarily see:

Before announcement:

• Stock price: $75
• 3-month 75-strike call: $3.50
• 3-month 75-strike put: $3.00

Immediately after announcement:

• Stock price: quickly drops to $74
• Call price: still at $3.50 (slow to adjust)
• Put price: quickly moves to $4.00

This temporary lag in the call option’s price adjustment creates an inefficiency traders may make use of through a conversion options strategy. The position would cost $74.50 ($74 + $4.00 – $3.50) but would ultimately be worth $75, creating a potential profit opportunity.

Merger arbitrage situation

When companies announce mergers, it can create complex pricing dynamics. Let’s say Company A announces it will acquire Company B for $100 per share, but Company B currently trades at $95 due to deal uncertainty. This might create the following scenario:

• Stock price: $95
• 6-month 90-strike call: $8.00
• 6-month 90-strike put: $2.50

The options market might not fully reflect the probability of deal completion, especially if the deal terms change. If you believe the deal has a high chance of closing, the conversion strategy could provide a way to capture the spread while maintaining protection against deal failure.

Changes in interest rates can affect the theoretical relationship between puts and calls. Quick changes in rates may lead to temporary mispricing as different market participants adjust their positions at different speeds.

Interest rate impact scenario

Let’s examine a scenario with a sudden 0.50% rate hike:

Before rate change:

• Stock: $100
• 1-year 100-strike call: $8.00
• 1-year 100-strike put: $7.00
• Risk-free rate: 4%

After rate announcement:

• Stock: $100
• Call price: quickly moves to $8.50
• Put price: still at $7.00 (temporary lag in adjustment)
• New risk-free rate: 4.50%

The lag in put option pricing adjustment creates a brief window for conversion strategies to potentially profit from the inconsistency.

All three components of the position should be executed simultaneously to avoid exposure to market movements that could eliminate the potential profit opportunity.

Use limit orders rather than market orders to ensure you receive the best price possible.

When determining position size, consider margin requirements and the overall risk profile. Remember that while the strategy is relatively low risk, it still requires careful capital management and understanding.

If you’re short the call option, be aware of potential early exercise risk around dividend dates. The risk is particularly high when the dividend amount exceeds the remaining time value in the call option.

Monitor significant changes in interest rates, as these can affect the profitability of existing positions. Consider adjusting positions if rate changes materially affect your expected return.

Increased volatility can create both opportunities and risks. Monitor how changes in implied volatility affect your position and be prepared to adjust as needed.

If the price discrepancy that prompted the trade persists, you may choose to hold the position until the option expires. The position will be worth the strike price at expiration, regardless of where the stock is trading.

If the price discrepancy corrects before expiration, consider unwinding the entire position to capture any profits. This approach can free up capital for other opportunities and reduce exposure to further potential risks.

In some cases, you may find opportunities to leg out of the position by closing individual components when favorable prices present themselves. However, this approach requires careful management of margin requirements and the remaining market exposure.

Poor execution across the three legs can eliminate potential profits. Use appropriate order types and consider the impact of transaction costs.

Monitor positions closely around dividend dates and be prepared to adjust if early exercise becomes likely.

Changes in interest rates can affect position profitability. Consider using shorter-dated options to reduce interest rate sensitivity.

Commission costs and bid-ask spreads can significantly impact profitability. Ensure your analysis includes all relevant costs before entering positions.