Assessing Bernie Madoff's Strategy

BERNIE MADOFF'S ALLEGED $50 BILLION Ponzi scheme appears to be a crime of historic proportions.

But elements of his options-based investment strategy may have merit -- if practiced by sound, honest investors.

By selling a call option on stocks his fund purportedly owned, and then buying a put option against those stocks, Madoff was hedging positions against declines and establishing an above-market sale price for the stock.

This strategy, known as a "collar," is often used to manage large positions in one stock, or to limit the risk of large stock portfolios. The amount of money received for selling the call sometimes pays for the put.

The "collar" strategy is a mainstay among many wealthy investors because of its ability to reduce the risk of stock ownership.

Unfortunately the way he used the strategy required the type of skill and timing that appears on Wall Street just a few times in a hundred years.

Yet, Madoff's elaborate trading scheme ensnared many of the world's most sophisticated investors, including investment banks and hedge funds that should know better. Fred Wilpon, the New York Mets owner, Leonard Feinstein, co-founder of Bed, Bath & Beyond (BBBY), Nomura Holdings, UBS (UBS), Tremont Capital Management, BNP Paribas, Mort Zuckerman, a real estate tycoon, and even Elie Wiesel's Foundation for Humanity all lost money.

Some people lost all of their money.

Madoff, a former Nasdaq chairman who had been well respected for his contributions to pioneering electronic stock trading, operated a separate money management business that is involved in Wall Street latest fleecing of trusting investors.

According to knowledgeble sources, Madoff told investors he could generate consistent returns by buying Standard & Poor's 100 Index puts, and selling out-of-the-money calls against a basket of blue-chip stocks that he bought on the "bid" -- the lowest possible market price, which also let him capture the "spread" or the difference between the bid and the ask.

The strategy makes great intuitive sense. The options component limits the risk, while the stock trading tactic sweeps the few cents or so that would otherwise be the profit of the market maker.

Of course, it is very hard to buy stocks on the bid -- which is the price investors are generally able to sell at. The options component has its own problems.

"Everyone ran numbers on this," said Jon Najarian, co-founder of OptionMonster.com, a trading advisory.

"I met with the man and didn't think he was a real (con) artist, but I didn't think he wanted to show me his strategy."

Najarian said no one could figure out how Madoff's strategy worked.

Indeed, Madoff needed impeccable timing and pristine market information - two traits that elude most of the world's investors. The slightest error in adjusting the short index call option, for example, would limits portfolio gains and would force Madoff to buy back the call at precisely the worst, and probably most expensive, moment.

"If you had a crystal ball," Najarian said, "why wouldn't you trade market direction if you could read trading flow? Why trade such a complicated position?"

The basic construct, though, of Madoff's strategy was sound, and is widely used on Wall Street.

Say you have $100 million of stock, received because you were an executive in a company that just sold stock in an initial public offering. All of a sudden, your family's financial future is tied up in the trials and tribulations of one stock.

The "collar" -- buying a put and selling a call -- alleviates some of these burdens by reducing the risk of one-stock wealth. High-net worth investors often like the strategy because it means they will never be worth less than a certain amount of money, even though they must forgo gains, usually 20% or so higher.

The "collar" can be managed, and the short call component traded in response to market conditions, but this type of investment management is not feasible for most people, not least of which is because it is exceedingly expensive to maintain a hedge.

The problem with the "collar" strategy is that it is often difficult to establish a meaningful upside, while also paying to hedge the downside. The options market is very efficient and opportunities to print money -- which is what a zero cost collar ultimately represents -- are rare.

"If Madoff was so good," says Michael Schwartz, Oppenheimer's chief options strategist, "why did he need other people's money? Why didn't he do it for himself?"

Many investors in Madoff's funds will likely ask themselves the very same question for a very long time.