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Part II. Convertibles, a Better Solution > 8. Enough Already...How Do Convertib...

8. Enough Already...How Do Convertibles Actually Work?

There are three basic ways to make money in convertibles: protected stock picking, prospering by surviving, and arbitrage. Beyond that, there’s one principle that overrides everything else: You make money buying convertibles from motivated sellers. Although that goes for pretty much any asset, it goes double for convertibles because of the narrow, close-knit nature of the convertible investing community.

Protected stock picking, for the most part, is the province of convertibles trading above par (100). It involves buying a convertible because you expect appreciation in the underlying stock and you think the convertible will participate acceptably. You recognize that because you are paying a premium for the convertible, over and above the bond’s conversion or pure stock value, your upside performance will lag somewhat behind the stock’s. That premium, essentially, buys you the protection of an ultimate floor for your investment. You’re willing to pay the premium because the ability to gain equity upside via a convertible gives you a degree of comfort you don’t get with stocks. That comfort comes from knowing that unless you’re tremendously wrong about the company....


  

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