How to find the right reverse convertible
Investors should develop a differentiated market assessment before buying, because as an investment instrument, reverse convertibles are not suitable for either rapidly rising or falling markets – in the first case, the profit is limited to the interest coupon, in the second case, the repayment of the capital is uncertain. Investors can use two parameters as a basis for their individual risk tolerance and return expectations: the position of the base price in relation to the current share price and the (remaining) term.
The lower the strike price is chosen, the lower the interest coupon and possible maximum return; at the same time, however, the greater the tolerance towards one’s own forecasting errors. A negative share price development can still be absorbed with a reverse convertible with a low base price without incurring capital losses. Even a very low basic price does not replace capital protection.
On the other hand, if you believe that the share has good price potential and does not expect a downturn at the end of the term, you can optimize your returns by choosing a base price that is at or even higher than the current price. The increased willingness to take risks entails a higher maximum return.
Extra tip: The yield potential of a reverse convertible generally increases with the term of the bond. However, investors should keep in mind that a reverse convertible represents a short put position based on the collection of an option premium – and thus benefits from the time value loss of options. According to the option price formula, this does not accrue linearly over the option term, but is highest in the last three months.
From an empirical point of view, price increases on stock markets are usually slow and continuous, while losses are often severe and quick: the better a company’s business performance can be predicted, the lower the uncertainty about its future and the lower the market’s assessment of volatility. Rising prices are often accompanied by declining volatility, falling prices by increasing volatility. For the synthetic, covered short put position in a reverse convertible, this can mean that positive effects from rising prices are reinforced by falling volatilities. Conversely, falling share prices can also have a twofold negative impact.
Before you decide on a specific reverse convertible, you should always ask yourself the following questions: