How to Trade Preferred for Common Stock

Common stock is what most people think of when they want to invest in the stock market, but there are two types of stock a firm can issue: common and preferred. Preferred stock is actually somewhere between common stock and bonds. While preferred stock pays a dividend (which is taxed like common stock), it does not give the shareholder voting rights, as common stock does. Some preferred stock, however, does provide an option to convert preferred shares into common shares.

Instructions

1. Understand the meaning of "convertible preferred." Convertible preferred stock allows the shareholder to convert preferred shares into common shares. The rate of conversion is set by the issuer. However, the conversion price depends on the price at which the common stock is trading.

2. Convert your preferred shares. Usually it is up to the shareholder to initiate conversion, but sometimes there is a provision allowing the company to force conversion. Check your prospectus or ask your financial adviser for information on how to initiate a conversion.

3. Work through an example. Let's say XYZ Securities issues $10 million in convertible preferred shares (bonds) at $1,000 a share. They are paying a 4.5 percent dividend. The conversion ratio is 7, which allows preferred shareholders to trade in one share for seven common shares. XYZ Securities' common stock is trading at $150 per share.

4. Calculate the annual dividend per share. At a 4.5 percent dividend for each share for $1,000 per share (preferred), this equals $45.

5. Calculate the conversion price. This is equal to the purchase price of the preferred shares divided by the conversion ratio. The market conversion price, or the price at which it becomes profitable to convert preferred shares to common shares, is $1,000/7, or $142.86. At this price, a shareholder would have a loss of approximately $7 per share ($150 - $142.86) if he wanted to convert or trade in preferred shares for common shares.

Tips & Warnings

• Preferred shareholders always get paid before holders of common shares.

References

• Investopedia: Convertible Preferred Stock
• Investopedia: Introduction to Convertible Preferred Shares