Hi @rfj5002! Thanks for reaching out!
When an investor converts a preferred stock or bond, the process may take a few business days. If this occurs, the investor is at risk of the common stock losing value before they gain their shares. Using easy numbers, let’s assume this:
- $100 par convertible preferred shares
- Preferred stock market price = $110
- Conversion ratio = 2:1
- Common stock market price = $60
Right now, converting the preferred stock into 2 shares worth $60 each is equal to $120 of value. Let’s assume the investor converts their shares, but has to wait two full business days before they obtain the shares. What if the common stock’s market price declines before they receive shares? For example, what if the market price falls to $40 by the time they receive the shares? The value of the conversion plunges from $120 to $80 (2 shares x $40).
One way to avoid this is to perform the same action referenced in your practice question. The investor should first sell short the stock at $60 (before it falls). They are not betting against the stock as would normally be the case with short stock positions. Instead, the investor locks in the sale price of $60 and must mark the sale as ‘short’ because they don’t yet have the shares. A few days later, the investor receives the shares and gives them immediately to their broker-dealer to close the short position.
The whole point of the short position is to lock in the sale price of the stock. By doing so, market price declines do not affect their profit.
Bottom line: ‘selling short the stock and converting the bond to close the short position’ is essentially the equivalent of ‘convert the bond and sell the stock.’
I hope this helps! Please let me know if you have any other questions.