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One of the most classic arbitrages involves buying a convertible preferred stock or bond and shorting the common. If you know and understand the terms of the convertible vis-a-vis the common, you could easily try to do a little old-fashioned arbitraging.

But in this day and age of computer trading, it would be difficult for the individual investor/trader to make more than a few pennies, if you're lucky, on such a trade as computers keep such arbitrages in line. Trading firms with deep pockets could do this trade many times over and could afford to carry such a trade if it needed to be carried for any length of time.

However, for the small independent trader like myself, I would consider writing calls against a convert, especially in a stock that has been beaten down like Citigroup (NYSE:C).

The particular convertible security I am referring to is the C Pfd. H, a mandatory convertible security.

The substantive terms of this particular convertible security can be summarized as follows:

* An owner of C Pfd. H receives $7.50 in dividends ($1.875 payable 3/15, 6/15, 9/15 and 12/15) and;

* C Pfd.H must mandatorily convert to C stock based upon the closing price of C stock on 12/15/2012. The conversion rate can be seen in table below.

Price of C on 12/15/2012 Conversion Multiplier
If C <= $31.50 3.1746
If C >= $39.40 2.53968
If C > $31.50 and C < $39.50 100/Price (eg. 100/$34.50 =2.898)

Knowing the terms of this convertible, lets fast forward to 12/15/2012 and analyze some scenarios based on closing prices:

Recently, C closed @ $31.25, and C Pfd. H closed @ $92.96

C - 12/15/2012 Conversion Price Dividends Total Return
$31.25 (unchanged) $99.20 (31.25 x 3.1746) $7.50 $106.70 or 14.7%
$40 $101.58 (40 x 2.53968) $7,50 $109.08 or 17.3%
$20 $63.49 (20 x 3.1746) $7.50 $70.99 or -23.6%

Now consider selling the C September 40 Calls that are now trading $1.53 - $1.58. You can sell 2.54 as many C September 40 Calls as shares of C Pfd. H that you own and you would be totally hedged even if the stock rallies above the $39.40 ceiling as per the conversion table.

Now lets add $3.93 (Sep. 40 Calls $1.55 x 2.54) to the same scenario:

C - 12/15/2012 Conversion Price Dividends Options Total Return
$31.25 $99.20 $7.50 $3.93 $110.63 or 19%
$40 $101.58 $7.50 $3.93 $113.01 or 21.5
$20 $63.49 $7.50 $3.93 $74.92 or -19.4%

Additionally, if your September 40 Calls expire worthless you could then sell December 40 Calls to enhance your returns.

If you like C, (and what's not to like, it has a low p/e and close to a $50 tangible book value per share), this is the trade to consider in lieu of buying C. Based upon the above analysis you would make some serious returns if C holds its own this year. As a matter of fact, your break-even point on this trade including the writing of the calls would be C @ $25.68 ($25.68 x 3.1746) = 81.52 + 7.50 + 3.93 = $92.56.

Disclosure: I am long C Preferred H

Source: Writing Calls against Citibank Convertible Preferred Stock