Convertible Arbitrage as a Strategy for Day Trading - dummies

Convertible Arbitrage as a Strategy for Day Trading

Day Traders use arbitrage tools — derivatives, leverage, short selling, synthetic securities — in many ways to generate profitable trades of stock and other securities. If you decide to do arbitrage, there are several useful strategies to follow including convertible arbitrage

As part of designing their capital structure, some companies issue convertible bonds (sometimes called a convertible debenture) or convertible preferred stock. These securities are a cross between stocks and bonds.

Like an ordinary bond, convertibles pay regular income to those who hold them (interest for convertible bonds and dividends for convertible preferred stock), but they also act a little like stock because the holders have the right to exchange the convertible security for ordinary common stock.

Here’s an example: A $1,000 convertible bond pays 7.5 percent interest and is convertible into 25 shares of stock. If the stock is less than $40 per share, the convertible holder will prefer to cash the interest or dividend checks. If the company’s stock trades above $40, the convertible holder would make more money giving up the income in order to get the stock cheap.

Because of the benefit of conversion, the interest rate on a convertible security is usually below that on a regular corporate bond.

Because a convertible security carries a built-in option to buy the underlying stock, it generally trades in line with the stock. If the convertible’s price gets too high or too low, then an arbitrage opportunity presents itself.

Consider this case: A day trader notices that a convertible bond is selling at a lower price than it should be, given the current level of interest rates and the price of the company’s common stock. So he buys the convertibles and sells the common stock short. When the stock’s price moves back into line, he collects a profit from both sides of the trade.