What Makes Covered Call Writing Different from Bernie Madoff's Notorious Strategy?

02/09/2016 8:00 am EST

Focus: OPTIONS

Alan Ellman

President, The Blue Collar Investor Corp.

Alan Ellman of TheBlueCollarInvestor.com illustrates that Madoff’s strategy—split strike conversion—actually has a lot in common with covered call writing. However, this key caveat makes all the difference between a legitimate options trade and an interminable prison sentence.

Covered call writing is my favorite stock investment strategy and Bernie Madoff is one of the world’s most infamous sociopaths. How can they exist in the same article title? Last week, ABC-TV aired a mini-series documenting the rise and fall of Bernie Madoff and his $65 billion Ponzi scheme. Madoff never actually ever invested the billions of dollars given to him by hedge funds, millionaires, charities, and retail investors looking to secure their retirements. Instead, he used the money for his own personal greed and power and put a title on how he pretended to accomplish the goals of consistent returns of 12% per year, even in years when the overall market was down substantially like in 2008. The name of his strategy was split strike conversion and it has a lot in common with covered call writing with the caveat that we actually execute our trades.

What Is the Split Strike Conversion Strategy?

On first glance, the name may appear impressive or even intimidating. In reality, however, it’s simply covered call writing with a protective put. We know it as the collar strategy. It’s so simple: Buy a stock, sell an out-of-the-money covered call, and buy an out-of-the-money protective put. We put a ceiling on potential gains and a floor on potential losses. Yes, folks, this is the secretive strategy of Bernie Madoff that led to so many lives being financially ruined…amazing isn’t it?

Example of the Collar aka Split Strike Conversion

  • Buy 100 x Company XYZ at $48.00
  • Sell 1 x $50.00 call for $2 (covered call)
  • Buy 1 x $45.00 put for $1.00 (protective put)
  • Net gain on the option buy and sale is + $100.00 ($200.00 – $100.00) per contract
  • This brings our cost basis down to $4700.00 ($4800.00 – $100.00) per contract

Outcome if Stock Price Surpasses the $50.00 Strike Price:

  • Shares are sold for $5000.00 ($50.00 strike x 100 shares)
  • Results in a profit of $300.00 ($5000.00 – $4700.00)
  • ROO = 300.00/4700.00 = 6.4%

Outcome if Stock Price Falls Below the $45.00 Strike Price to $43.00:

  • Shares are sold for $4500.00 (not $4300.00) because of the protective put
  • Net loss is $200.00 ($4700.00 – $4500.00) = (-) 4.3%

Outcome if Stock Price Remains at $48.00:

  • ROO = $100.00 ($100.00/$4700.00) = 2.1%

Chart of Possible Outcomes

chart
Click to Enlarge

Madoff’s Twist

Madoff pretended to buy shares in a major index and then buy and sell options on the index itself. Index options are cash-settled unlike stock and exchange-traded fund options where shares can actually change hands. Perhaps this twist is what threw off some of the more knowledgeable investors like other fund managers…but it was probably simply greed and laziness to perform adequate due diligence. To read the entire article click here…

By Alan Ellman of TheBlueCollarInvestor.com

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