Could You Make Money the Madoff Way?

You can expect to hear about Bernie Madoff's $50 billion Ponzi scheme for months to come. As with most scandals involving the financial markets, it mostly boils down to this: Someone decided to get greedy, and that person got caught ... but only after doing a lot of damage to people who trusted him.

For those looking for a silver lining from all this, one question to ask is whether the strategy that Madoff purportedly used to generate all his profits could actually work. Madoff's materials refer to using a "split-strike conversion strategy" as the source of his outsized returns -- yet even options experts were never able to reproduce his results.

So what's behind the strategy behind the scandal everyone's talking about right now?

Put a collar on it
As described in various publications, the split-strike conversion strategy Madoff allegedly used involved a combination of stocks and options. Specifically, according to various sources, Madoff bought 30-35 stocks from the S&P 100 index. He then bought put options on the index at strike prices below the market's current level and sold call options above the index's current price.

That sounds appropriately complex -- complex enough to confuse many of Madoff's investors. But in reality, it's only a little more complicated than a simple option strategy called a collar.

With a collar, you buy a put option that lets you sell your shares for a set minimum no matter how far share prices fall. To get the cash to buy the put, you also sell a call option, giving someone else the right to buy your shares for a given higher price. By choosing the right options, you can set up the collar so that the proceeds from selling the call pay for the put you buy.

Essentially, the net result is that rather than facing the possibility of a total loss or having the opportunity for huge gains, you limit both your potential losses and gains to a fixed range.

The strategy in action
Let's take a look at a few of the S&P 100 stocks Madoff may have used to see how this strategy works in practice.

Source: CBOE. Option and stock prices as of Dec. 17.

To understand the chart above, take a look at Amgen. Skipping past the options jargon, here's what would happen when the options expire in April:

• If the stock fell below $45, you'd exercise your put and get $45 -- a loss of around $13.50.
• If the stock rose above $70, your call would get exercised and you'd receive $70 -- a gain of $11.50.
• If the stock ended between $45 and $70, you'd keep the shares with whatever gain or loss they'd had in the interim.

Simple, yes? Maybe -- but far from risk-free.

It might have worked -- until it didn't
The Madoff strategy was a bit more complicated than the example above, as it involved a basket of stocks plus index options. But because he apparently chose stocks that were highly correlated with the S&P 100, the strategy would likely have worked in a somewhat similar fashion.

For the strategy to work best, stocks would need to rise slowly but steadily. That way, you'd get regular gains from your stock holdings, but the options positions wouldn't make you miss out on any extraordinary gains. In hindsight, much of the period from 2003 to 2007 offered conditions where the strategy might have worked well.

Yet, at least in these simple terms, the strategy wasn't absolutely loss-proof. Although the put protection would reduce losses, it wouldn't eliminate them completely. So it's not surprising that the scam finally came to light during one of the worst bear markets in history.

Lesson learned
The Madoff scandal is a great reminder that as an investor, you should always understand what you're buying -- and under what conditions it could create losses. By knowing exactly what you're getting into, you'll know when things look fishy -- and potentially get out before the bottom falls out.

To learn more about options and investing, read about:

• A simple introduction to options.
• Options strategies that actually work.
• How to invest in today's market.

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