Convertible arbitrage is a trading strategy capable of providing profits even if you don’t know what is happening in the technical chart. It is fantastic to find the price discrepancies among market instruments and make a profit from them.
However, you cannot simply open a trading account and initiate convertible arbitrage. It needs additional research and knowledge about how arbitrage works. In the following section, we will see the complete trading guide on convertible arbitrage in forex trading. After completing the whole section, you will get the knowledge to make money in any currency pair using the arbitrage system.
What is convertible arbitrage?
It is a trading method where the money comes from the different behavior of similar assets on various platforms. In traditional arbitrage trading, investors should look for a trading asset on multiple platforms to see whether there is a price discrepancy or not. They can easily make money as the different prices will come closer, today or tomorrow.
In the convertible arbitrage approach, we need to find a company’s ordinary share capital trading at a higher price than the convertible bond of that company. Therefore, buying an asset at a low price and selling another at a higher price would benefit the market.
For example, you can easily arbitrage if a trading asset is trading at the New York Stock Exchange at $10 and the same asset is trading at another platform with $12. You have to buy from $10 and sell from $12 with an immediate $1 profit.
However, arbitrage trading needs close attention to the price, and its profits are generally lower than the average. Investors might have to use advanced technologies to find quick price change from different platforms.
How to identify convertible arbitrage?
Convertible arbitrage involves trading with convertible bonds with the ordinary share of a particular company. Most hedge funds and financial institutes use this method to make easy money from the financial market. Moreover, it will extend the profitability in case of a sharp movement after opening the trade.
If the stock keeps moving, the short position will be capped since the profit on convertible securities is offset. This is because the debenture or convertible bonds usually provide profit at a coupon rate, and its gain will be compensated for the trading cost of ordinary shares.
On the other hand, the hedge ratio is an essential factor that a trader should consider while performing convertible arbitrage trading. For example, if you invest $10,000 in foreign equity and use $5000 as the currency position, your ratio will be 50%.
A short-term strategy
This method includes both buy and sell trades together where the ideal trading environment comes when the ordinary share price is trading higher and the convertible bond is trading lower.
Bullish trade setup
As seen in the above section, convertible arbitrage involves buying a bond at a lower price. In that case, you need to apply a simple technical analysis knowledge and find the bond at a suitable buying zone. The price should be above any significant support level and should reject from the intraday event area.
Bearish trade setup
While taking the buy trade on the convertible bond, you have to open a sell trade immediately. The ordinary share should trade at a higher price and show a bearish rejection from any significant resistance level. Later on, open the sell trade and get out of the market with profits from bullish and bearish trades.
A long-term strategy
The long-term method is similar to the short-term one, where the main investors’ focus should be to find the difference between ordinary shares and convertible bonds. Make sure that you are focusing the same context on the broader view. So in this method, you might have to wait days to see the profit coming.
Bullish trade setup
In the buy setup, identify the convertible bond of a company that is trading at a lower price and open a buy position here from a significant price level. It could be after a rejection from a substantial support level.
Bearish trade setup
While taking the buy trade, you need to make sure that you are opening a sell trade on the ordinary share of that company from a higher price. In that case, find the stock price below any critical resistance level and open a sell trade after a strong bearish rejection.
Pros and cons
Let’s see the pros and cons of the convertible arbitrage trading strategy.
|The convertible trading method has a higher winning ratio as it considers the price discrepancies between the convertible bond and ordinary share price.||There is no guaranteed profit in the convertible arbitrage trading method.|
|This method is applicable in any financial market.||It is often hard to find buying and selling entries at a suitable price.|
|Convertible trading needs less knowledge about advanced technical and fundamental analysis.||Convertible arbitrage needs close attention to the trade management system.|
Convertible arbitrage trading systems have everything to allow you to include in your trading portfolio. However, the global financial market is associated with some risks that no one can ignore. Therefore, make sure to use appropriate trade management to remain profitable. The best approach is to use a portion of your investment per trade, not more than 2% of your overall capital. For an aggressive approach, this percentage can be higher but taking too much risk might blow your account at any time.