Do-It-Yourself Convertible Arbitrage

My thinking is that the worst is over for El Paso, but I don't want to take a chance on additional writedowns or other future headline risk. However, I do want to be able to capture the dividend of the preferred and also capture some of the upside in the stock. That makes this an interesting convertible arb.

Again, the idea is to go long the preferred and short the common, but I would not be completely dollar-neutral (meaning you are long the stock a dollar amount equal to the amount you are short the stock) because I am mostly bullish on the company. Because the common moves faster, you don't need to short the equivalent amount of common. In fact, if the stock goes up, then shorting the equivalent amount of common could end up losing money. Additionally, it must be noted that shorting the common requires the short-seller to pay the common dividend, reducing the gain of the dividend on the preferred.

My play here would be to go long the preferred, and short $30 of common for every $100 I was long the preferred. This provides most of the benefit from any appreciation in the stock as well as most of the benefit from the dividend. However, if additional headline risk results, then the downside has a cushion because the common will fall faster and harder than the preferred.

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