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:

  1. 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.

  2. 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).

  3. Exercise of the warrant usually involves some dilution of the underlying stock, while no such dilution occurs with exchange-traded options.

Because the pricing of a convertible's embedded warrant is a bit more complex than a straight option, you need to employ a convertible model to help price these strategies. Many option sites, such as the Chicago Board Options Exchange, offer this type of pricing algorithm. They can play a key role in uncovering convertible buying opportunities. Like a regular covered call, there's no margin on a convertible covered call, provided that the total shares indicated by the conversion ratio of the convertible(s) are greater than or equal to the call option's underlying shares.

In screening convertible call candidates, you should take into account more than just the pricing factor. First, you need to determine if the combined position will be bullish, bearish or neutral. For the most part, the same rules that apply for 1-to-1 option spreads apply to convertible covered calls:

  • 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.

Finally, you should determine if you'd be willing to convert into stock if the call is exercised. Many times, in the case of likely redemption candidates, the investor may be willing to deliver the underlying shares. But in most other cases, the trader would probably rather buy back the shares than convert the bond.

Happy trading.
By Jeff Neal, contributing writer and options strategist at Optionetics.com. Send him email at jeff@optionetics.com.