Convertible preferred stock provides shareholders with the security of a fixed income investment, but offers the option of converting the shares to common stock under certain conditions. Convertible preferred stock pays regular dividends that are tied to interest rates, not market fluctuations like common stock. Those with convertible preferred shares also get preferential treatment in two ways: they receive dividends before common stockholders, and if the company goes bankrupt, preferred shareholders are paid before common stockholders.

While preferred stock is considered more stable, it does not hold the same potential for large financial gains as common stock. Convertible shares, however, offer the investor the opportunity to benefit from an increase in share price over the preferred stock conversion price. This can be beneficial to investors who want to cash in on growth industries without risking large losses if the stock price declines. However, the overall value of the convertible stock is still contingent on the performance of the common shares.

Shareholders generally initiate the exchange of convertible preferred stock for common shares, but under certain conditions, companies and stock issuers also can force conversions. When considering the exchange of convertible preferred shares for common stock, be sure to note the conversion ratio, which represents the number of common shares stockholders receive for every convertible preferred share.

The conversion ratio, which is determined by a company before stock is issued, also indicates the price that the common stock needs to be for the shareholder to profit from the exchange. The conversion price is equal to the purchase price of the preferred share divided by the conversion ratio. For example, a $125 stock with a conversion ratio of 7 would have a market conversion price of $17.86. To read more about convertible securities, visit www.sec.gov.