Split Strike Is a Valid Strategy, Despite Madoff Scandal

This whole Bernie Madoff thing has made the split-strike option strategy infamous. I’m sure a lot of people who had never really heard of or understood options scrambled to make sure none of their investments were using a similar strategy. The split strike strategy involves buying a basket of stocks, then writing call options against those stocks, and finally using the proceeds from writing the call option to purchase a put option.

The strategy, in theory, should provide market returns minus extremely bullish or bearish results, depending on how far out of the money the call and put options are. For example, a manager might buy the S&P 500 (which we’ll use the SPYs as a proxy for) at $91 and sell the January 09 $95 strike calls for $2.22 and buy the January 09 $87 strike puts for $2.92. In effect the manager is paying $0.70 for the insurance that the SPY position will not be worth less than $87 and not more than $95 on Jan 16th 2009. Rinse and repeat this every month and the performance of this manager will more or less be market performance minus the cost of insurance. It would be impossible, as Madoff critics point out, for the manager to avoid losses in months where the market goes down.

So the split strike option strategy is a viable way to reduce risk and reward. I haven’t done the math to see if it offers superior risk/reward when compared with just the index return, but it’s also important to realize that the protection offered could bring measurable psychological benefit. Sometimes, even if it costs some performance, it’s better to be able to sleep at night.

On the subject of options, it is important to note that the implied volatility on put options is materially higher than call options. In the example from the first paragraph the implied volatility for the calls is 37% and 45% for the puts. Effectively this means, all else equal, that put options are more expensive than call options. This means that option buyers think there is a higher risk of the market going down, in effect the profitable (risk free) trade right now is to short the SPYs ($91 at time of writing), write put options at the money ($4.55 at time of writing), and purchase calls ($4.00 at time of writing). If the market goes up or down you won’t lose (or make) any money, leaving you with proceeds of $0.55 on $91 for 1 month (7.2% annualized, arithmetically). This arbitrage (7.2% risk free versus 2 year yield of 0.68%) opportunity is part of the reason why the market is having trouble getting past this current level. When this reverses it will be a sign that the markets are prepared to go higher.

Finally, we can make it an all options day and I’ll discuss what I would do if I was running a portfolio right now (I am still running the mock portfolio, but I don’t think this strategy would fit within the guidelines of that fund). When you write a put option, what you are doing is giving someone the RIGHT (but not obligation) to sell you the underlying security at a specific price. In effect you are opening yourself up to buying something at a specific price.

Once again looking at the SPYs, I think that $85 (850ish S&P) is a good entry point. While, in the long run, I think the S&P 500 will easily surpass its old highs… that doesn’t mean I want to pay $91 (910) for it today. By writing $85 put options (January strike, $2.33 at the time of writing) I am setting myself up for two possible outcomes, the market goes higher and I collect $2.33 for writing the option or the market goes materially lower (than 850) and I buy the index where I would have bought it anyways. So if I was running a $100mm fund, and I wanted a 70% exposure to the market, I could write approximately 8,230 put option contracts and be paid $1.9mm per month (assuming volatility stayed approximately the same). In other words, by writing put options (and holding the 70% allocation in cash) and waiting for my desired entry price, I would be earning 2.7% per month on my $70mm market allocation (the other risk of this strategy is that the market flies up to 1,200 or something in which case you miss out on big gains). If the market were to drop precipitously I would be entering the trade at an average price of $82.67, and I would still be materially ahead of most of my competitors… were I running a fund.

Stock position: None.

Comments

[rayman:]

Excellent article - you could further minimize risk with a split strike "butterfly" (buying OTM options beyone the split strikes as insurance), however, there again you eat into potential profits. Still, I like the insurance.

2008 Dec 22 06:03 AM

[kotika98:]

the call options we are talking about here are plain stock options, and for puts, the index options. Evaluating this requires sophistication not available to average Shmoe - in fact i would compare this to dispersion trades, except this is even more complicated due to the "split".

For what its worth, Markopolos, the guy who sounded alarm to the SEC and anyone who would listen, definitely thinks that the strategy as stated is incapable of the results Madoff showed. Markopolos argues, and I agree that "splitting" the strike would actually make results worse, not better on average.

And suppose someone is evaluating a manager who is claiming that the key to performance of this split strike strategies is stockpicking like Madoff claimed - that would be a definite red flag.

Jan 01 09:09 AM

[firstproman:]

As always the objective dictates the strategy. If outperforming S&P or any diversified index is the objective it's hard to see how this paysoff (insurance and transaction costs). IF, as with pessimists such as Taleb Nassim, your objective is reaping bounty during sudden crashes or surges (black swans) while beating "normal" bond yields then there may be some merit in a defensive option strategies e.g. doubling up on the long option AGAINST the current technical trend. In today's market (Jan '09) that would entail a short SPY position, buying x2 nearby calls and selling a further out Put for a small COST (implied vol favours PUTs currently).

Jan 29 12:40 PM