Series 3: 5.1.4. Conversions

5.1.4. Conversions

A conversion is the combination of a synthetic futures contract or synthetic stock with the underlying security or futures contract itself. A forward conversion combines a long security or futures contract with a short call and a long put (a short synthetic). A reverse conversion combines a short futures contract (or stock) with a long call and a short put (a long synthetic). If the purchase price of the conversion is cheaper than the strike price of the synthetic, then one can lock in a profit that will be maintained however prices subsequently move up or down.

Let’s try an example to see how this works.

Example: Your soymeal futures are currently trading at 316. You short September 320 calls, which are out of the money and selling at 14 cents. At the same time, you buy long September 320 puts, currently in the money and priced at 17 cents. The cost of your forward conversion is the price of the futures contract (316) plus the cost of the long September put (17) minus the price of the short September call (14). This totals 319. Since the cost of the conversion is less than its strike price, your conversion can lock in a ri