In the world of stock trading, it can get a bit confusing, especially on the jargon that traders usually use when talking about business and their portfolio with a colleague or even a competitor. You might be wondering, what if these jargons are applied to people who haven’t got the slightest idea of what was being discussed. In this article, we will be focusing on one of these terms and get an inside look of what it really means and how it really works.
Convertible Arbitrage is a common strategy that is being utilized by big traders and hedge fund managers. This strategy poses a possibility of lower risk and bigger gains with its long-short position. Using the short position during times of stock decline will mostly benefit the trader while the long position takes in convertible security which is then issued by the company using the same strategy.
How does the Convertible Arbitrage work?
This strategy is quite beneficial to a hedge fund because at a certain time that convertible security and a stock plunge, it will still pay out a dividend higher than the usual, which is what it means when they say that it poses a lower risk.
But due to the fact that the loss was covered during the stock plunge, if ever the stock gains its momentum again, the short stock will then have to offset it coming from convertible security.
This type of strategy is commonly done by an 'Arbitrageur’, basically is an investor attempting to get profits from the inefficiencies of the prices in the market by trading simultaneously in order to offset each other from the long-short position to gain that profit that will be completely free of risks. Investors will buy listed stocks that are undervalued and then short sell most of the overvalued shares which compensate for the loss of the other to make it free of risks.
The same process also applies to cryptocurrency trading, as when an arbitrageur will notice a big difference in the selling process between two markets. The trader will then simultaneously buy cryptocurrency from Market 1 and sell it at a higher price in Market 2, assuming that Market 1 is making fewer sales compared to Market 2. This process is done in order to compensate for the loss in Market 1.
Important Things About Convertible Arbitrage
· Although we have mentioned earlier that this strategy is free of risks on the gains side of trading, there are still some factors that will affect the market in the long run. One example is the credit risk that there can be some investment grades that are below or not even rated at all that promises huge returns will surely pose an existence of a significant risk.
· The volatility and young nature of the cryptocurrency can also pose a risk when it comes to convertible arbitrage trading. The competition that will arise from the growing popularity of the cryptocurrency will also encourage the increase of traders that results in overcrowding and will result in greater loss in the stocks.
· Another issue that arbitrageurs have to worry about when trading cryptocurrency is is the issue concerning the liquidity of this asset. Buying and selling in bulk quantities to small traders usually becomes hard to liquidate when they are selling it to larger companies.
· The continuous fluctuation and unstable nature of the cryptocurrency exposes your assets to more threat as the government regulation imposes limits on the withdrawal of these assets.
· Different kinds of currencies also pose a risk for this strategy as with the multiple crossing of borders which mainly involves different types of monetary form that eventually means the risk grows higher that forces Arbitrageur to utilize currency futures in order to offset any known risk.
The convertible arbitrage strategy is not completely immune to the unpredictable changes in the stock market. Cryptocurrency trading still has a lot of discrepancy issues in which there are instances that happen when this strategy backfired when the convertible security plunges and the underlying stock rises all the way up. It will be very beneficial if the movement of the stock market is closely monitored and has a heads-up when situations arise of when the volatility of the market is exposed that can have an effect of maximum benefit for the trader.