Just Because Madoff Used It Doesn't Mean the Collar Strategy Is Tainted

People in finance LOVE to use big words. For instance, if you buy a stock, and then simultaneously write an out-of-the-money covered call, and the use the proceeds of that call to buy a protective put, most people know the strategy as a “collar”. But the folks in high finance call it a split-strike conversion. I know why they do it, because a conversion-reversal is a way to trade options risk-free. You don’t make a lot of money at it, but when done right, it truly is risk free. A conversion reversal is the exact same strategy as a collar, only the options you are using are at-the-money options — the same strike. By calling a collar a split-strike conversion, you create the impression of having some of that “risk-free” association.

This split-strike conversion was supposedly the strategy employed by Bernard Madoff — the now-infamous purveyor of the world’s biggest heist. [In a sweet bit of karma, Madoff took heed of Willie Sutton’s advice of robbing where the money was, targeting wealthy Florida and New York country club members, who themselves probably got rich off of flipping condos and investment banking.] For more information on Madoff and the strategy, the go-to source is Nakedshorts. Greg Newton dug up an old Managed Accounts Reports (MAR/Hedge) article that is filled with priceless irony.

With all of that said, the reason I write today is to dispel any taint that might befall the collar strategy. It’s a terrific strategy in all sorts of conditions. I’ve used it personally, although primarily in futures trading. It’s a great way to protect yourself if you feel the need for that kind of protection. There’s even a mutual fund, The Gateway Fund, that uses this exact strategy. They’ve been around for 30 years, and they’re audited and registered. Bottom line, just because a scammer touted a certain strategy, don’t think that the strategy itself is flawed. The use of options to reduce risk and increase risk-adjusted performance is something that every investor should consider.

For an out-loud belly laugh — I Knew He Was Cheating, That’s Why I Invested With Him.

Comments

[notsosmart:]

in this country any scam,lack of accountability,lack of transparency,out & out lying,is fine be it legal or illegal as long as all are making money.once it got going nobody could have stopped this latest fiasco.there were a few voices of warning but they were kept in the wilderness.madoff would have continued for years if the situation had not crashed.the sec is just part of the system to protect the inside manipulators,scoundrel... & scammers.the secret dealings the govt. considers legalon wall st.makes it worse than vegas.the sheeples will be fleeced all the time.so lets have a brewsky & talk sports.LOL

2008 Dec 14 11:24 AM

[Donald Johnson:]

Lesson to be learned: How did Madoff missuse the collar strategy and lose money using it?

Anybody care to speculate, if I may use that word?

2008 Dec 14 03:51 PM

[Land of Won...:]

Madoff did not use the collar strategy. He used the Ponzi strategy. He paid longer-term investors with money coming in from new investors, and the jig was up when the hedge funds who invested with him started liquidating and he could not raise the cash.

Madoff only claimed to use the collar strategy, and perhaps he did at some point, but he abandoned it. It does not generate the kind of constant, consistent positive returns that he achieved. It can reduce risk, but it can't eliminate it.


On Dec 14 03:51 PM Donald E. L. Johnson wrote:

> Lesson to be learned: How did Madoff missuse the collar strategy
> and lose money using it?
>
> Anybody care to speculate, if I may use that word?

2008 Dec 14 10:21 PM