Conversion: What it is and How it Works in Options Trading

What Is a Conversion?

A conversion is the exchange of a convertible type of asset into another type of asset—usually at a predetermined price—on or before a predetermined date. The conversion feature is a financial derivative instrument that is valued separately from the underlying security. Therefore, having an embedded conversion feature adds to the overall value of the security.

Understanding a Conversion

An example of an asset that can undergo conversion is a convertible bond. This type of bond gives the bondholder the option to exchange the bond for a predetermined amount of the bond issuer's equity. Typically, the bondholder will exercise the option when the total value of the shares received from conversion exceeds the bond's worth.

For example, suppose that Jill owns a convertible bond worth $1,000 from XYZ Corp. If the bond can be converted into 100 shares of XYZ, Jill will most likely exercise the conversion option only when XYZ's share price exceeds $10. The conversion ratio or conversion price of a convertible bond is usually outlined in the trust indenture at the time the bond is issued.

Another security that includes a conversion feature is preferred shares. Shareholders have conversion rights, which give them the ability to convert preferred shares to common shares if the results are advantageous to the investors. The share prospectus given to shareholders at the time of issue includes the conversion ratio—the number of common shares into which the preferred shares can be converted.

For example, suppose that Jane purchases a preferred stock for $100 with a conversion ratio of four. This means she can convert one preferred share for four common shares. The conversion price is $25 ($100/4 = $25), which is the price that would make it worth converting the preferred shares into common shares. Jill will most likely exercise her conversion option if the price of the common shares increases above $25.

In most cases, the holder of a security with a conversion feature determines whether and when to convert. In other cases, the company has the right to determine when the conversion occurs. Either way, converting preferred stock into common stock dilutes the percentage ownership of existing common shareholders. Since convertible securities are converted into newly issued stock, the new stock increases the total outstanding shares in the market, which decreases existing shareholders’ ownership of a company. The share dilution, in turn, shifts fundamental positions of the stock such as ownership percentage, voting control, earnings per share (EPS), and the value of individual shares.