what you are reffing to is a old strategy (and very commn in todays use, still) which hedge funds use to generate secure profit.
It called convertible arbitrage.
(Convertibles = Options)
it is most important to find a option which is in the money. once you found it you can buy with money you have or you buy or margin (with credit) times 4 or 5. now 5% gain in 3 months doesnt sound so awesome but combine it with a money put down of 20% and the rest on margin (leverage 5) and you have a gain of 25% if you dont convert your option, if the price rallies by 20% and you convert all your options you have a gain of 100% within those 3 months.
Funds usually take a delta neutral approach into this, you can increase your risk by not hedging in the security itself but hedging in another option on leverage, thus increase your delta but in same time increase your reward (alpha).
you get what i mean.
i wont type my fingers bloody onto what how where who so ill just copy pase:
4 Convertible Arbitrage
Convertibles generally are the hybrid securities including a combination of a bond with an equity option.
A convertible arbitrage hedge fund typically includes long convertible bonds and short a proportion of the shares into which they convert.
In simple terms it includes a long position on bonds and short position on common stock or shares.
It attempts to exploit profits when there is a pricing error made in the conversion factor i.e. it aims to capitalize on mispricing between a convertible bond and its underlying stock.
If the convertible bond is cheap or if it is undervalued relative to the underlying stock, the arbitrageur will take a long position in the convertible bond and a short position in the stock.
On the other hand, if the convertible bond is overpriced relative to the underlying stock, the arbitrageur will take a short position in the convertible bond and a long position in the underlying stock.
In such a strategy managers try to maintain a delta-neutral position so that the bond and stock positions offset each other as the market fluctuates.
(Delta Neutral Position- Strategy or Position due to which the value of the Portfolio remains unchanged when small changes occur in the value of the underlying security.)
Convertible arbitrage generally thrives on volatility.
The reason for the same is that, more the shares bounce, more the opportunities arise to adjust the delta-neutral hedge and book trading profits.
Example of Convertible Arbitrage Strategy
Visions Co. decides to issue a 1-year bond that has a 5% coupon rate. So on the first day of trading it has a par value of $1,000 and if you held it to maturity (1 year) you will have collected $50 of interest.
The bond is convertible to 50 shares of Vision’s common shares whenever the bondholder desires to get them converted. The stock price at that time was $20.
If Vision’s stock price rises to $25 then the convertible bondholder could exercise their conversion privilege. They can now receive 50 shares of Vision’s stock.
50 shares at $25 is worth $1250. So if the convertible bondholder bought the bond at issue ($1000), they have now made the profit of $250. If instead they decide that they want to sell the bond, they could command $1250 for the bond.
But what if the stock price drops to $15? The conversion comes to $750 ($15 *50). If this happens you could simply never exercise your right to convert to common shares. You can then collect the coupon payments and your original principal at maturity.