Consider today the plight of federal inmate No. 61727-054, formerly known as Bernard L. Madoff, sitting in his penthouse cell and getting to know cellmates Max the Murderer and Igor the Rapist. Exclusively, we were able to place a hidden microphone in the cell and can now bring you an extract of a recorded conversation in which Bernie explains to his new neighbors the option strategy he claimed to follow over the 20+ years during which he ran the largest Ponzi scheme in history.
Max: Bern, how much money did you say you made?
Bernie: Well, between 1990 and 2005 returns averaged 12% a year.
Igor: That’s pretty good, but I’m not wowed given the inflation over that time. I can make more robbing banks. How come people gave you billions?
Bernie: That’s the thing, Our range of annual returns was 6.23% to 19.98%. That’s a very narrow range. What’s more, in 14 years we had only 7 small monthly losses.
Max: Pretty neat. What instruments did you use? Extortion, thumbscrews, knives?
Igor: My mom has a basket.
Bernie: We used these to implement split-strike conversions. Collars.
Igor: Whoa,..don’t talk to me about gettin’ collared.
Bernie: Not collared, collars. Let me explain in terms of the steps we took. We started with a pot of money from investors. First, we invested that in a portfolio of 30-35 blue-chip, large capitalization stocks. Companies like IBM, Coca-Cola and General Motors.
Igor: GM. I thought you said large caps?
Max: Schhh. This isn’t today. This is back when the Cadillac Cimarron was the “Star of theAmerican Road
Bernie: Second. We would sell call options against the OEX index. Roughly the right number of option contracts to correspond to the dollar value of shares we owned. Third, we would use part of the proceeds from the call sale to buy put options on the OEX. Again, we would roughly fully hedge the dollar value of long stock we held.
Max: So you were fully hedged, right?
Bernie: Correct. By the way, how did you learn about hedging?
Max: A bank I turned over used it for clients.
Igor: But hang on Bernie. Can’t those stocks go down?
Bernie: Sure. But then what happens to the value of the puts I bought? They go up by roughly the same amount.
Max: So no net change in the value of your position.
Igor: If your stocks go up Bernie. How do you make money given that you sold calls equal to the dollar value of the stocks you own? Dat’s my worry.
Bernie: This is a split-strike conversion. So the call strike is above the put strike. Therefore, the value of the position does go up a bit before the call strike is hit. As prices move higher than that point, the gain on the stock is roughly offset by the loss on the call option.
Igor: Neat. So is that the only way you make money?
Bernie: No, we receive income three ways. There’s the appreciation of the stock that I just referred to. There are dividends on the stocks. And there’s premium income on the call options we write. That’s how we end up with an average of 12% investor return per year. Note also that the position is virtually risk free.
Max: Cool. Lenny the Knife, a hit man down in Brooklyn, would really like that. He’s very risk averse and his return on treasuries has really taken a tumble. He could take his money out of treasuries, put it into Bernard Madoff Securities and make 12% risk free instead of 1%. This sounds like an offer he couldn’t refuse!
Igor: Hold on a minute. Doesn’t this all assume some mispricing? That is, shouldn’t the annual return on risk-free conversions be the same as on other risk free positions, e.g. treasuries?
Bernie: That’s just ivory tower nonsense.
Igor: What about the dividend return on the stocks? That can’t be more than 2%.
Bernie: Err, if you say so.
Igor: And the premiums from selling the calls. If the strike prices are much higher than the market price, that won’t be much. Another 2%?
Bernie: Could be more.
Igor: And buying all those options. They must cost at least 8% a year. How did you still pay out 12% to your investors?
Bernie: We are brilliant stock pickers.
Max: I’ll say. You paid out 12%, right? So you made more than that to cover expenses. What was the pre-expense rate of return?
Bernie: We sold through intermediaries a lot, so-called ‘funds of funds’, so we had to make 16% just to pay them.
Max: It don’t add up Bernie. You use a well-established, low-risk to no-risk strategy and make returns that make you the toast of your investors. There must have been money managers who refused to put a penny with you.
Bernie: Just professional jealousy.
Igor: And the SEC, didn’t they spot you immediately.
Bernie: My brother-in-law was my accountant and I had my own brokerage firm, so the only way you would have spotted anything is if you understood option theory and saw the claimed returns vs. the strategy. How many option experts do you think there were at the SEC?
Max: And you were big. Couldn’t I have looked at the volume of OEX options traded, For example you had, say, $20B of stocks. So if 10,000 OEX contracts traded at $10 the dollar volume hedged was 10,0000 x 100 x $10 = $100M. Not nearly enough to hedge your portfolio of stock. That would have been a red flag.
Bernie: I used OTC options.
Igor: But even if you did. I would have expected the brokers who were on the other side of those transactions to hedge in the equity, exchange traded option, or futures markets. But I don’t see the volume there. So where did the investor’s money go? Did you Madoff with it Bernie?
Bernie: Well, I ran a Ponzi scheme. If you got out early enough, you got the money. The gains never existed, In fact, after a time the trades didn’t happen either. But it was fun at the time.