Conversion and Reversal

Conversion and Reversal refers to a synthetic strategy in options trading used to exploit mispricing between the options market and the underlying asset market. A conversion involves selling a call option, buying a put option with the same strike and expiration, and buying the underlying asset to create a synthetic short position that is risk-free if priced correctly.

A reversal is the exact opposite, involving buying a call, selling a put, and shorting the underlying asset. These strategies rely on put-call parity, a fundamental principle stating that the price of a call and a put with the same strike and expiration must be related to the price of the underlying asset.

When the market price of the options deviates from this theoretical parity, traders execute these trades to lock in a riskless profit. In cryptocurrency markets, these strategies are often executed on decentralized exchanges or derivatives platforms to arbitrage price discrepancies between spot and perpetual futures.

The strategy effectively eliminates directional risk, leaving only the profit from the mispricing. It is a cornerstone of market microstructure, ensuring that derivative prices stay in alignment with spot prices.

These trades require efficient execution to capture the small spreads before they disappear.