We know this for sure: Bernie Madoff was running a Ponzi scheme and not really investing his clients' money. So ... the strategy he professed to use - split-strike conversion - is bunk too, right? Well, not exactly. (Learn to avoid scammers in How To Avoid Falling Prey To The Next Madoff Scam.)

While the split-strike conversion strategy, sometimes called a collar, is a bit complex for the average investor, it is a viable strategy. In fact, it's so legit it's typically included in options texts. The premise is to reduce the volatility, provide consistent returns and protect against loses. As it turns out, you can invest like Bernie and not go to jail. Read on to find out how his infamous strategy works.

Split-Strike Conversion, Step by Step

  1. Buy shares of companies to create a portfolio that represents a major index like the S&P 500. There's no need to buy the entire index, just 25 or 30 of the firms that move very closely with the overall index, preferably with high dividend payouts.
  2. Sell call options at a strike price above the current index. While this will limit gains, it will also generate cash.
  3. Buy put options at the current index value or very close to it using the call option premium cash. These will pay off if the index falls, thus limiting or preventing losses. (For more on collar strategies, see Putting Collars To Work.)

The (Legal) Outcome

A split-strike conversion strategy can have several outcomes - none of which involve jail time:

  1. The market moves up big and the call options that were sold get exercised. In this case, you would have to pay a cash settlement to cover the loss, but the portfolio gains a similar amount. You still gain the premium, which is profitable, just not as profitable it could have been.
  2. The market moves down big and the put options you bought pay off. Here, you'll still have your portfolio, but the value will be lower. However, because the put options paid off, that gain offsets some of the portfolio losses and you get to keep the money generated from writing the call options. This can also be profitable. If it's not, it will at least limit any losses.
  3. The market doesn't move big at all and the money generated from writing the calls covers the purchase of the puts and the stock portfolio generates dividends. Again, the outcome is positive.

Why It Failed for Madoff

If this sounds really good to you, then you can understand why it sounded so good to Madoff's investors. When you have a good story about your strategy and back it up with consistently positive results, it's a convincing presentation. It's no wonder his business grew so large.

But there are other potential outcomes where this strategy can lose money. For example, if an investor buys put options near the current market price, the expense would be much higher than the future call options. So, he would either have to buy significantly more call options to generate enough cash to buy the put options or leave some of the portfolio unprotected. If the investor buys out-of-the-money puts, which would be cheaper, and the index slowly drifted downward with moves that didn't trigger the put options, the result would be a loss. Talking about the strategy can make it sound like a sure winner, but actually executing it is easier said than done.

One of the main reasons Madoff's strategy wouldn't have worked for him in reality was that the size of his fund was so large, the volume of option trading would have had a great impact on the market. There would have to be enough demand for the call options and enough supply of the put options to equal the size of the portfolio. With billions to invest, there just aren't enough counterparties willing to take the other side of the trade for him to work the strategy at any reasonable price. Also, all that trading would have generated significant costs, eating into returns.

The Split-Strike Blues

Bernie Madoff's infamous bust has given the split-strike strategy a bad rap. In fact, the strategy is sound. Madoff used his double talk to make investors believe it could generate the above-average returns they believed they were getting. It was a hoax. Madoff could never have generated the returns he said he did with this strategy, nor could he have used it with such a large fund.

Madoff could have used this strategy, generated returns for this clients and avoided breaking, but it wouldn't have been as profitable (for Madoff!) and the fund never would have grown to the size it did.

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