subject: When To Hedge A Reverse Convertible Note (rcn) [print this page] A Reverse Convertible Note (RCN) is a short-term investment vehicle linked to an underlying common stock, sharing some of the characteristics of both bonds and stock. Premock Financial in South Florida uses RCNs as part of an investment strategy that provides clients with "Solutions for Life." One of the primary benefits of an RCN is its high coupon payoffs, which are dependent upon the equity markets. When an RCN matures, investors may receive either the full amount of the original investment or a predetermined number of shares of the common stock to which it is linked, as well as fixed income payments.
Premock Financial in South Florida advises that if an RCN is trading at or near resistance (the top of the box) at issuance, a Put option hedging position is immediately attached to the RCN in order to protect against the possibility of a stock price failing to break above the resistance level. Resistance might push the stock lower, which increases the risk of the stock price plunging below the downside barrier.
However, if a hedging position is in place at the resistance level and the stock price pushes above that level, the hedging position will begin to decrease in value. This potentially decreases the total rate of return from the RCN stated coupon rate. Stop losses therefore protect every RCN used by Premock Financial in South Florida. When used appropriately, RCN hedging positions only mainly threaten the total rate of return, rather than the principal. If the stock price cannot break through the resistance level and does not close below the downside barrier, its possible for the hedging position to earn a profit.
If the underlying stock that is linked to the RCN is trading at or near the support level at issuance, according to Premock Financial in South Florida, a hedging position will not be immediately attached. When a stock trades low to support, it is likely that the RCN will not breach the downside barrier. Chances are that the stock price will bounce off the support level.
If the underlying stock of an RCN is trading more or less between resistance and support levels at issuance, there is really not any immediate need for a hedging position. The downside barrier protection usually suffices to allow for price fluctuations between strike and trigger prices. If, however, the downside barrier is breached, especially if there is no spike in volume, a hedging position will be attached. This will help offset the principal loss if the stock price continues to decline in value and does not recover to stock price before maturity.
