Reversal

What is a Reversal?

A reversal is the mirror image of a conversion. You short the stock, sell a put, and buy a call at the same strike and expiration. The short stock plus the short put creates synthetic short call exposure. By buying an actual call, you lock in any pricing discrepancy.

Like a conversion, this is an arbitrage strategy that exploits violations of put-call parity. The profit is locked in at entry regardless of where the stock goes. It is delta-neutral and direction-neutral — the outcome is predetermined.

Reversals are used by market makers and institutional traders. When they identify that the synthetic position (short stock + short put) is cheaper than the actual call, they capture the difference by putting on the full reversal.

How to Set It Up

• Short 100 shares of the stock
• Sell 1 put at strike A
• Buy 1 call at the same strike A
• Same expiration for both options
• Strike selection: ATM is most common for liquidity.
• Expiration: Any. Longer expirations may present larger mispricings.
• Net cash: You receive cash from shorting the stock and selling the put. You pay for the call. The net should be close to the present value of the strike.

This is a "reverse conversion" — the exact opposite of a conversion. Everything that applies to a conversion applies here, just flipped.

When to Use This Strategy

Use a reversal when:

• You identify that the call is cheap relative to the put (put-call parity is violated in your favor)
• You are a market maker looking to capture pricing inefficiencies
• You want to earn the interest on the short stock proceeds (when rates are high, this matters)
• You are managing a complex options book and need to hedge exposure

Retail traders rarely use reversals. The edge is tiny and execution costs usually exceed the profit. But the concept is foundational to understanding options pricing.

Example Trade

Stock XYZ is trading at $100. Options at the $100 strike with 60 days left:

• Short 100 shares of XYZ at $100.00
• Sell 1 XYZ $100 put for $3.80
• Buy 1 XYZ $100 call for $3.50
• Net credit from options: $3.80 - $3.50 = $0.30 ($30)
• Cash received: $10,000 (stock) + $380 (put) - $350 (call) = $10,030

If XYZ drops to $90: You buy back the stock at $90 via the put (assigned). The call expires worthless. You spent $10,000 through the put and originally received $10,030. Profit: $30.

If XYZ rallies to $110: You exercise the call and buy stock at $100 to cover the short. You spent $10,000 and originally received $10,030. Profit: $30.

If XYZ stays at $100: Both options expire worthless. You close the short at $100. Profit: $30.

Same outcome every time. That is the nature of arbitrage.

Risk and Reward

• Max profit: The arbitrage edge. Minimal — typically pennies per share.
• Max loss: Minimal if executed properly. Execution risk (partial fills, slippage) is the main concern.
• Breakeven: Not applicable in the traditional sense. The profit or loss is locked in at entry.

The profit reflects the interest earned on the short stock proceeds minus any borrowing costs and dividend obligations.

Tips and Common Mistakes

• Short stock has borrowing costs. You need to borrow shares to short them. The borrow fee eats into (or exceeds) the arbitrage profit. Hard-to-borrow stocks can make reversals unprofitable.
• Dividend obligations. When you short stock, you owe dividends. If there is a dividend before expiration, factor it in.
• Early assignment risk on the short put. The put buyer can exercise early. Be prepared for this.
• This is mainly educational. For retail traders, the value of understanding reversals is in learning put-call parity, not in trading them.
• Watch for seemingly free money. If a reversal looks too profitable, you are probably missing a dividend, a borrow fee, or a data error.

Related Strategies

• Conversion — the opposite: long stock + long put + short call
• Synthetic Short Stock — the options-only component (long put + short call)
• Synthetic Long Stock — the opposite synthetic position