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.

Related Articles
  1. Options & Futures

    What Does Quadruple Witching Mean?

    In a financial context, quadruple witching refers to the day on which contracts for stock index futures, index options, and single stock futures expire.
  2. Fundamental Analysis

    5 Basic Financial Ratios And What They Reveal

    Understanding financial ratios can help investors pick strong stocks and build wealth. Here are five to know.
  3. Options & Futures

    4 Equity Derivatives And How They Work

    Equity derivatives offer retail investors opportunities to benefit from an underlying security without owning the security itself.
  4. Stock Analysis

    3 Obscure Twitter Accounts Making Money Off of You (TWTR)

    Learn how Twitter accounts that share quotes or information, such as @HistoryInPics and @Notebook, make money from their audiences.
  5. Investing

    What Investors Need to Know About Returns in 2016

    Last year wasn’t a great one for investors seeking solid returns, so here are three things we believe all investors need to know about returns in 2016.
  6. Investing News

    ABC's Madoff Miniseries Explores His Charm, Smarm

    An ABC miniseries on Ponzi scheme king Bernie Madoff gets inside the head of a man who was, in fact, not too big to fail.
  7. Options & Futures

    Five Advantages of Futures Over Options

    Futures have a number of advantages over options such as fixed upfront trading costs, lack of time decay and liquidity.
  8. Term

    What is Pegging?

    Pegging refers to the practice of fixing one country's currency to that of another country. It also describes a practice in which investors avoid purchasing security shares underlying a put option.
  9. Economics

    Why Enron Collapsed

    Enron’s collapse is a classic example of greed gone wrong.
  10. Home & Auto

    Understanding Pre-Qualification Vs. Pre-Approval

    Contrary to popular belief, being pre-qualified for a mortgage doesn’t mean you’re pre-approved for a home loan.
RELATED FAQS
  1. What is a derivative?

    A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, ... Read Full Answer >>
  2. What is finance?

    "Finance" is a broad term that describes two related activities: the study of how money is managed and the actual process ... Read Full Answer >>
  3. What is after-hours trading? Am I able to trade at this time?

    After-hours trading (AHT) refers to the buying and selling of securities on major exchanges outside of specified regular ... Read Full Answer >>
  4. What is the difference between positive and normative economics?

    Positive economics is objective and fact based, while normative economics is subjective and value based. Positive economic ... Read Full Answer >>
  5. How do hedge funds use equity options?

    With the growth in the size and number of hedge funds over the past decade, the interest in how these funds go about generating ... Read Full Answer >>
  6. Can mutual funds invest in options and futures? (RYMBX, GATEX)

    Mutual funds invest in not only stocks and fixed-income securities but also options and futures. There exists a separate ... Read Full Answer >>
Hot Definitions
  1. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
  2. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
  3. Ponzimonium

    After Bernard Madoff's $65 billion Ponzi scheme was revealed, many new (smaller-scale) Ponzi schemers became exposed. Ponzimonium ...
  4. Quarterly Earnings Report

    A quarterly filing made by public companies to report their performance. Included in earnings reports are items such as net ...
  5. Dark Pool Liquidity

    The trading volume created by institutional orders that are unavailable to the public. The bulk of dark pool liquidity is ...
Trading Center