Reversal

Conversion: LONG stock + Long put + Short call → Locks in SELLING price. Reversal: SHORT stock + Long call + Short put → Locks in BUYING price. They're mirror images. Conversion receives dividends but pays stamp duty. Reversal pays dividends but avoids stamp duty (must pay borrow instead).

When you short sell, you borrow shares from someone who would have received the dividend. You must compensate them. This 'manufactured dividend' payment is a liability that reduces reversal profitability.

To short sell, you must borrow shares from someone who owns them. Borrowing has a cost (like interest on a loan). Borrow rates range from 0.25% to 100%+ annually depending on how hard the stock is to borrow. This cost directly reduces reversal profit.

Yes! Lenders can 'recall' borrowed shares, forcing you to cover your short. This is why institutional traders sometimes use 'term borrows' with a fixed duration. Recall risk is a real operational concern.

It depends! In the UK: Conversion pays 0.5% stamp duty but receives dividends. Reversal avoids stamp duty but pays borrow fees and dividends. For low-yield stocks with cheap borrow, reversal may win. For high-yield stocks or hard-to-borrow, conversion may win.

Borrow Cost = Stock Price × Borrow Rate × Time. Example: 500p stock, 2% annual borrow, 60 days: 500p × 0.02 × (60/365) = 1.64p per share. This must be subtracted from reversal proceeds.

Early assignment is likely when: (1) Put is deep ITM, (2) Time value is less than interest on strike, (3) Near expiration. If put is only slightly ITM with time value, assignment is unlikely. Deep ITM puts are almost certain to be assigned early.

You must cover your short by buying stock. Your options remain open. You've converted from reversal to just holding the option positions (long call, short put = synthetic long). You'll need to decide whether to close the options or let them run.

Hard-to-borrow = high borrow rate for reversal but no stamp duty. Easy-to-borrow = low borrow for reversal, but conversion still pays stamp duty. Usually: Easy borrow → Reversal may be better. Hard borrow → Conversion likely better despite stamp duty.

They exploit opposite mispricings. If calls are expensive relative to puts (conversion expensive), then reversal is cheap. Market makers do whichever is mispriced. Also, reversal avoids stamp duty which matters for some institutional trades.

When you short sell, the cash proceeds can be invested. Institutions often receive a 'rebate' on this cash, typically close to the risk-free rate for easy-to-borrow stocks. Net borrow cost = headline borrow rate - rebate. Retail usually gets zero rebate, making their effective cost higher.

Options prices imply a borrow rate through put-call parity. If options-implied borrow differs from actual borrow, arbitrage exists. Example: Options imply 2% borrow, but actual is 5%. Reversal using actual borrow is unprofitable even if options seem fairly priced.

Dividend swaps allow trading expected dividends. If you're uncertain about dividends in a reversal, you could hedge with a dividend swap - lock in the dividend you'll owe. This creates more certain reversal economics but adds another leg and cost.

Triggers: High short interest, takeover bid, merger arb activity, index rebalancing. Management: Use term borrows to lock in rates, have backup strategies, monitor rate daily, have threshold for unwinding if borrow spikes.

Must ensure exact match: options on same share class as borrow. Example: Unilever has UK and NL listed shares. Options may be on one, borrow on other. Cross-currency and basis risk if mismatched. Always verify deliverable matches option specification.