How Did Madoff Claim He Was Investing People’s Money?

Not unlike a large number of people in this country, I find the Bernie Madoff scandal fascinating, so when I saw HBO was doing a movie with Robert DeNiro I was pretty excited.  I find the story so intriguing for a few reasons, but the main two are that I know a few people personally affected, and to a much larger extent, it builds into my obsession with wondering just how many people are completely faking and full of shit.  While watching, Wizard of Lies,  with The Wife I started to wonder what the hell was Madoff’s claimed strategy. I am completely familiar with the psychological part of pushing people away until they are begging to get in, but at some point, he had to explain what his investment style was, even if it was purely fake.

Before I even hit the google machine to start looking, I knew it was an options-based strategy, but I didn’t know it was going to be one I had never heard of before.

What Was Bernie Madoff’s Investment Style? Introducing The Split-Strike Conversion

Bernie Madoff claimed that he was using a Split-Strike Conversion options trade.  I know it is easy to throw out the baby with the bath water in this type of situation, but you have to separate the two.  Remember, this is the strategy that Madoff claimed he was using, but in actuality, he was running the world’s largest illegal Ponzi scheme.  Interestingly one of the individuals who tried to warn the world about the Bernie Madoff Scandal, Harry Markopolos, stated he couldn’t actually be using the strategy,

Over time and with some simple math calculations, Markopolos concluded that for Bernie Madoff to execute the trading strategy he said he was using he would have had to buy more options on the Chicago Board Options Exchange than actually existed, yet he says no one he spoke to there remembered making a single trade with Bernard Madoff’s fund. (emphasis added)

So, the first step someone has to take is understanding that the split strike conversion options strategy is not inherently fraudulent.  The investment strategy is no different than some of the other options strategies I looked at like the naked put, bull put spread, straddle, and strangle.  Now that we are past that we can learn about the strategy together (much like my other posts, I am going to learn while preparing the post).

What is a Split Strike Conversion? What is a Collar?

A split strike seems to be the same thing as a collar which is,

…a protective options strategy that is implemented after a long position in a stock has experienced substantial gains. An investor can create a collar position by purchasing an out-of-the-money put option while he simultaneously writes an out-of-the-money call option. A collar is also known as hedge wrapper.

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A collar may also describe a general restriction on market activities. An example of a collar in market activities is a circuit breaker that is meant to prevent extreme losses (or gains) once an index reaches a certain level. However, the term “collar” is more often used in options trading to describe the position of being long put options, short call options and long shares of the underlying stock.

Let’s break it down piece by piece:

1. We own an underlying long position.  Obviously, this would have to be at least 100 shares since we are talking about options.
2. We sell covered calls.  When you sell a call you are guaranteeing that you’ll provide 100 shares (1 contract) of an underlying stock or index at a price previously determined.  In this particular strategy, the calls sold would be out of the money (i.e. above the current price of the stock) and covered (we own the stock; this is the opposite of selling a naked call).  If the stock does not hit that predetermined price then there would be no reason for the buyer to “call” the stock from you at a higher price than they can get it on the open market.  The covered calls are out of the money and generate return/income.
3. We purchase a protective put.  When you buy a put you are buying the opportunity to put a stock or index to someone at a predetermined price (no matter how low the stock may go).  It is called a protective put because we are protecting our long position from a sudden drop in the stock.  This protection costs money and is offset by the income generated by the covered call.

Bernie Madoff Scandal: An Example of a Collar or Split Strike Options Strategy

I find that when I am learning new strategies it is best to use an example:

• I own 100 Shares of ABC at $50/share
• I sell a covered call with a strike price of $55 that expires in one month  – this generation is $50 (.50 * 100 shares = $50 for one contract)
• I buy a protective put at $45 that expires in one month – this costs $40 (.40 *100 shares = $40 for one contract)

My possible outcomes in one month’s time:

• The stock finishes between $45.01 and $54.99 – I keep my $10 and any dividends that were paid on ABC
• The stock finishes above $55 – my shares get “called away” at $55 and I receive a 10% capped profit.  If the stock finishes that month at $65 I left a lot of gain on the table.
• The stock finishes below $45 – I get to put my 100 shares to someone at $45.  If the stock takes a real nose dive I will have lost the $5/share between my $50 basis and the $45 strike price, but I may not have lost what I could have lost if the stock is actively trading at $30 on the open market.

Would I Ever Enter into a Collar or Split Strike Options Contract?

Absolutely.  I think this is a fantastic strategy to implement once I get to 100 shares on my long-term holds from way back in my dividend growth days (feels like a lifetime ago since I stopped because of some naked puts that went south on me).  When/if I get around to implementing this strategy I think I’ll be going way out of money and just generating some cash to further my investing.

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