Pimp My Trade

Bernie Madoff’s Failed Trading Strategy

Posted on March 8, 2009 by Adam

If you have been following the news, you may have heard that the SEC recently released a copy of this report, which was submitted in 2005 by a whistleblowing Wall Street insider, warning regulators of the vast fraud underway in Bernie Madoff’s fund. The SEC completely ignored the warning, submitted by Harry Markopolos long before Madoff was even investigated.

The report detailed how Madoff ran his fund, describing everything from what he describes as the “World’s Largest Ponzi Scheme,” to how Madoff actually managed his securities.

I wanted to take some time to discuss the specific strategies that Madoff used to manage his portfolio. While in no way do I condone any of the strategies used, I want to talk about them to shed some light on why he needed to run a Ponzi operation in the first place. Madoff began as a legitimate fund manager who generated some pretty decent losses with his “proprietary strategies,” and rather than admit the truth, he turned his operaton into a grand Ponzi operation.

The report describes how Madoff used some complicated options strategies that supposedly only generated two monthly losses over the course of years! I wanted to talk about why that’s simply impossible. By understanding what Madoff did wrong, you can better your options trading.

What is a Split-Strike Conversion Strategy

Bernie Madoff used what is called a Split-Strike conversion strategy to “generate his market beating returns.” I put that in quotes, because this strategy is extremely difficult to profit with, and would only work in very specific markets.

The first component of Madoff’s strategy was to buy 30-35 large cap stocks, such as GM, XOM, CAT, etc, earning about 2% per year from dividends. Madoff then sold covered calls on out of the money S&P 100 index options.

If you are not familiar with covered calls, it works like this. Say I purchase one million shares of the SPY for $69, which is current market value. Then I go to the options market and sell 10,000 front month call options with a strike price of $75 for 60 cents each. Each option contract controls 100 shares of SPY, so I am selling options that control 1,000,000 shares - enough to cover my long position.

The buyer of the contracts I am selling has to pay me - 10,000 (number of contracts) * $0.60 (price of contract) * 100 (number of shares per contract) - a total of $600,000. That buyer has paid me for the right to buy 1,000,000 shares of SPY at $75 per share. If he chooses to exercise that option, I have the obligation to sell him those shares at the agreed price.

Here is a summary of my position so far:

1 million shares bought @ $69 each = -$69 million

10,000 calls sold at $60 each = +$600,000

For a net position of: -$6.84 million

Now let’s look at two possible outcomes of this scenario:

First, let’s say that the option contracts expire a month later and SPY is trading at $70. The buyer of the calls can choose to exercise his contracts here, paying $75 per share, but it would be cheaper for him to just buy the shares on the open market for $70 each. Most likely, he will not exercise his options.

Even though the options were not exercised, I still keep the $600,000 in premiums I received from the sale of those options. Not only did I make that money, but my shares have appreciated in value by one dollar. I have gained $1.6 million dollars using a covered calls strategy.

On the other hand, say that the options expire when SPY is trading at $77 per share. The buyer of our calls can choose to buy from me at $75 per share, or buy on the open market for $77. Most likely, he will choose to buy from me, since I am obligated to sell to him at a $2 discount. However, my cost basis on the stock was $69 per share on the 1 million shares I own, so I still make 75-69 = $6 per share, plus the revenue from the sale of the options. I end up selling the option buyer my million shares, for a net gain of $6.6 million dollars on the position.

That’s a covered call strategy, and it works unless the price of the stock goes down below my cost basis. Even in that case, the revenue from the option sales help to offset my loss.

Bernie Madoff sort of did that, but he didn’t sell options on the stocks he owned - he bought specific stocks, and then sold index options, so it wasn’t really a covered call strategy. He was long stock and short naked calls, as we would say.

If the buyers of Madoff’s options chose to exercise them, he was obligated to sell them shares that he did not own. He would then have to find shares to borrow so he could sell them to the buyers. Not only that, but by getting short the market, he was in an unlimited risk position. If the market rallied, he stood to lose more than he invested.

As a general rule of thumb, don’t sell calls on a stock you don’t own. You are taking on unlimited risk, which you should always try to avoid.

But that’s not all. There’s more to the Madoff strategy.

After buying stock and selling naked index calls, he would then buy out of the money index puts. This is similar to the Covered Call Collar option strategy, except it involves index options rather than options on the stocks traded.

This offers some insurance in case the stock price decreases and serves to limit risk to the downside. However, in up markets, being long put options limits upside potential. In up markets, put options would be a big drag on Madoff’s portfolio.

A coverd call collar can offer modest returns in a sideways market, but not like the 12% returns advertised by Madoff. In addition, he didn’t really run that kind of strategy.