Bernie Madoff perpetrated the biggest Ponzi scheme in history. It's estimated that 65 Billion USD of his clients' money has disappeared. In the media many analysts have talked about how secretive he was with his "secret sauce". In the past people suspected his miraculously consistent returns were due to his market maker operations employing "front running" trades. This involves placing advantageous trades just prior to execution of other big trades that the firm sees coming in. In hindsight that has turned out not to be the case - it was a straight out Ponzi scheme running clandestinely next to his market making operation. But it has been reported that Madoff did say his returns were the product of a split-strike conversion investment model. So what exactly is that? After a bit of digging around I think I can offer a non-expert opinion of how that works...

First some basics. In options trading a simple "buy and write" strategy involves buying a stock (the "buy" part), and writing an out-of-the-money covered call (the "write part"), meaning the strike price of the option is greater than the current buy price of the stock. Since you are writing the call you collect the premium up front. If the stock price doesn't move you won't be exercised - the options you sold expire worthless - and you keep the option premium. If the stock goes up by an appropriate amount you will get exercised so you deliver the stock you already bought, hence the name "covered call", but you still keep the option premium. If the stock goes down, again you're not going to get exercised on the written call, but you still keep the option premium. Of course the value of the long position you are holding is going to reduce but this loss is cushioned by the premium earned on the option. In summary, you profit if the stock price increases but this profit is capped by the option premium + the difference between the purchased stock price and the option strike. If the stock goes down your loss will be offset by the premium collected, so overall the buy-and-write outperforms a strategy that merely involved buying the stock, unless of course the stock price goes above the said (initially out-of-the-money) option strike price. [For simplicity this analysis ignores transaction costs.]

Taking this one step further. If you use the proceeds of the written call to buy an out-of-the-money put option, sometimes referred to as a protective put, this strategy is then termed a “collar” or a split-strike conversion. Purchasing an out-of-the-money put gives you the right but not the obligation to sell the stock at the predetermined strike price on or before the expiry date, thus you are protected from large downward moves. So now let's consider the pay-off matrix for such a strategy by examining the differences between this and the above buy-and-write strategy. In effect the upside profit is still present but the unlimited downside we had with the buy-and-write has now been limited to the strike price of the purchased put option. Thus a collar protects you from massive losses but it also prevents massive gains.

So now you know. The split-strike conversion strategy that Madoff claimed to be his secret sauce is just a trade that consists of a long equity position plus a long put and a short call. It's not a bad strategy, but it's obvious to everyone that it cannot produce positive results when markets go down which begs the question why he would offer such a strategy to fund managers who would know that?

If you want see empirical evidence that it is not possible to produce such consistently good returns with this strategy go read this paper.

Bookmark and Share