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How to make money in today's economy with arbitrage!!!!



November 11, 2008 – Comments (0)

Ok most of you know how to make money in arbitrage already using convertable bonds, but if you don't I would suggest reading a good investment book before trying my advice. Typically abitrage using converts is trying to pick a convert that you think will go up in stock price and taking advantage of the conversion ratio. ie.... ABC stock is selling for $20 and the $1000 5% bond has a conversion ratio of 50:1. When the stock price goes to $25, you immediately convert the bond to stock and sell the stock for $1250. A good way to make a quick 12.5 percent profit with the only downside being the %5 or so your gonna make off the bond if you don't convert, but picking this type of stock in this market is hard if not impossible.

Now we'll take it to another level, for you to get the most out of your pick, you want to pick a convert that has the longest timeframe possible. The more time you have, the better chances for results. In a good economy I would also look for a stock with more volatility, but in this economy it isn't necessary.

Now lets say you buy the same ABC convert and also short 25 shares of ABC stock. (Exactly half of the shares that you would get from the convert.) There are 3 possible scenarios...

 1) The stock price stays the same. You make 5% off the coupon payments on the bond. You'll also make interest off the cash from your short sale which should be more than the interest your being charged for borrowing the shares from the broker. All of this varies between brokers (which is why you should shop brokers if your doing this, and maybe use 2 brokers) but for simplicity sake, lets say you just made 6% total. Not bad in a bear market.

2) The stock price goes down. You don't convert your bond, so it's still worth 5%. ($50) Let's say the stock dropped to 15 to keep the math simple. You buy 25 shares to cover the short at 15 and you make $125 ($5 * 25) = 17.5% interest so far, plus the interest on the cash of the short sale minus the interest for borrowing the shares. Lets say 18.5% total.

3) The stock price goes up.  Again to keep the math simple, let's say it goes up to $25. You immediately convert making the share value $1250. (assuming that you haven't gotten any coupon payments yet, then it would be more to the money made.) You use 25 shares to cover the short. So right now you have 25 shares valued at $25 or $625. Since you don't have to buy shares to cover the short, you pocket the proceeds from the short sale ($500), so the total now is $1125. (or 12.5% interest) Adding the interest for cash and subtracting the interest for borrowing stock, let's say you made 13.5%

Ok I lied there are more than 3 scenarios...  but for most of them you can make even more money if your are a smart investor. The stock can go up and go back down or the stock can go down and then back up ect... The smart thing in any scenario is to take the sure money and not get too greedy. When the stock goes down, cover the short, and when it goes up, convert. Once you make 1 action, your risk is limited to missed opportunity only. If you don't take any action and the stock stays put, you should make your 6%. On the other hand if you totally miss an opportunity to cover or convert you'll be out a lot more money than if you play it safe! If you can get upside in both directions, you should out-perform a one-sided play percentage wise.

Why this is good in this market... I looked at this because my grandfather has come into some money that needs to be invested and given that he is 83 and has no guarantee that he'll out-live the bear market, I was looking for something conservative that will give him the best chance to make some money. Chances are in this market, that scenario 2 will be most common, but a bear market has built in volatility, which is good for this play. I don't have to guess the turn of the market and I can set limit orders to mange everything. Granted, it's tough to pick the converts initially, but after that, there isn't much analysis involved. With this strategy I also don't have to predict a market turnaround! I just do what I do and wait for the market to tell me it made a rebound.

Why this may not work for everyone... This takes math, and lots of it!  You have to pick the right convert and the right brokers and understand what the costs will be ahead of time. If your the type of person that worries about the dollars, and lets the nickles and dimes work themselves out, this may not be your best strategy.

 Disclaimer... I haven't actually tried this yet. I'm planning to when grandpa does finally get the money he is expecting though. You should still do your own research, as I'm still doing mine. If anybody can point out something I'm missing, please post. Both I, and my grandpa thank you ahead of time.

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