What is a Convertible Hedge?

Convertible hedges are one type of arbitrage strategy that can be implemented by purchasing a convertible security issued by a given company, while at the same time short selling shares of that same corporation’s common stock. The idea behind a convertible hedge is to take advantage of what is presumed to be an upcoming period of flat performance for the common stock. Assuming the price of the stock does remain at the same level for an extended period of time, the investor will tend to benefit from the hedge.

One key aspect of successfully completing a convertible hedge is placing the proceeds from the sale of the common stock into some sort of interest bearing account. This allows the proceeds to continue to generate some sort of return, although the return is usually quite modest. However, this represents a wiser use of resources than holding on to stock that is projected to remain flat for the foreseeable future.

As a precaution, the acquisition of the convertible security issued by the same company that issued the common stock places the investor in a solid position. In the event that the stock performs as expected and does not increase in price, then the return generated by the interest bearing account represents some return. However, should the stock begin to rise in value unexpectedly, the acquired convertible security may be eligible for conversion into shares of common stock. This would allow the investor to get back into the stock trading activity with ease, and possibly benefit from the sudden change. The two pronged approach to the convertible hedge thus represents one of the more balanced investment strategies in use today.

Choosing to engage in a convertible hedge is not something to be done lightly. Generally, an investor would do well to consult with a broker before executing the two orders required to create the hedge. Careful scrutiny of the performance of the stock should be conducted, as well as a hard look at the terms and conditions associated with the convertible securities. The convertible hedge should only be implemented after the investor is assured that the stock will remain relatively calm for an acceptable period of time.