Options traders should have a feel for the seldom-talked-about strategy known as covered calls on convertible securities. Let's discuss what it is, the mechanics of putting together the trade, the risks and, of course, the key factors to remember for executing these types of positions.
The convertible consists of an interest-bearing instrument and a warrant, which is a certificate offering the right to purchase common stock at a specified price over a specified period. Then you write a short call on the same underlying stock. Writing this call adds income to the convertible position but limits some of its upside potential. In some cases, the short call can actually cause the combined position to lose money if the stock rises far enough. As a point of reference, a convertible's embedded warrant differs from a call option in three ways:
- The effective per-share strike price is determined by the convertible's investment value as a straight bond or preferred divided by the conversion ratio. A convertible can usually be called after a period of time so the company can force early exercise of the warrant (i.e., conversion into the stock). Exercise of the warrant usually involves some dilution of the underlying stock, while no such dilution occurs with exchange-traded options.
- If the effective strike price of the convertible (calculated by dividing the investment value by the conversion ratio) is lower than the call's strike price, then the convertible covered call is bullish. If the two strike prices are equal, the convertible covered call tends to be a neutral position that generates income if the stock doesn't move, but can incur losses if there is a large move in either direction. If the short call's strike price is lower, the combined position will have a bearish bias. Typically, maximum profit for a convertible covered call occurs when the stock ends up at the strike price of the short call.