Learning from Madoff’s expensive lesson
Today's Financial News - Posted December 16, 2008
Bernie Madoff is teaching investors a very valuable lesson. First, he has reinforced the incredible value of proper due diligence. But most importantly, he is casting light on some very profitable options trading strategies.
By Andrew Snyder, TodaysFinancialNews.com
Baltimore – (TFN): The scandal following Bernie Madoff’s arrest is creating havoc throughout Wall Street. Billionaires, hedge funds, institutional investors and even large charitable organizations are wondering what in the world just happened. They thought they had millions, in some cases billions, and now it is gone.
But while these big-time investors are suffering, the news is proof that the little investor has some unique trading advantages.
Madoff’s so-called trading technique is nothing innovative. Options investors have been using “collar” strategies since the derivatives were first traded. It is a strong and reliable strategy that allows investors to essentially pre-determine their profit and loss ranges.
If he could do it on a small-scale basis, Madoff had a potential winner on his hand. By holding an equity and then selling calls and buying puts based on the underlying position, the former Nasdaq chairman promised to protect his investor’s money and offer them market-beating performance.
It would work, if he actually used it
His only problem… he had too many investors.
Madoff could not buy enough options to come remotely close to protecting his client’s billion-dollar portfolios. It would take over 300,000 S&P 100 options contracts to adequately hedge the $50 billion investigators say Madoff had under control.
On most days, however, only a few hundred of the contracts change hands. In other words, the hedge fund was too big for its own good.
But for you, the average investor, Madoff’s strategy is one to pay attention to. There has never been a better time to use a “collar” strategy to boost your portfolio’s overall safety and performance.
The system allows you to essentially pick your exit and entry prices, assigning a maximum loss and a maximum gain.
Of course, for many novice and greedy investors, the notion of limited gains is anathema to their traditional logic. But in this market, any gain is notable and to gain with limited downside is a rare bonus.
Take notes
Here is how options collars work:
The strategy takes a total of three positions: an underlying equity, the sale of a call option and a purchase of a put option.
For example, let’s say Joe the Investor buys 100 shares of XYZ for $25. To create a collar position, he must sell an out-of-the-money call option on the underlying equity and buy an out-of-the-money put option. The spread between the two options contracts is dictated by an investors risk tolerance.
We will say Joe sold calls with a strike price of $27 for a $3 premium and bought puts with a strike price of $23 for $2 per contract. This is a fairly typical, low-risk technique.
Now, let’s look at how these figures work together.
The underlying shares of XYZ cost Joe $2,500. But he sold the call contract for a $300 premium ($3 X 100), which was his to keep no matter what the stock did, and bought the put for $200 (again, 2 x 100).
In all, the options play netted him $100 (the $300 call premium minus the $200 expense to buy the puts). That means his true entry price for the XYZ shares is $2,400.
Making some money
So what happens if XYZ’s value begins to climb? If shares climb past $27, the calls will be exercised and Joe will be forced to sell his shares for $27, a gain of 12.5% above his realized entry price of $24 per share. Not too bad.
But like I mentioned above, the goal of this strategy is to minimize an investors downside risk. So let’s look at what happens if shares of XYZ begin to fall.
If Joe looks at his ticker and sees his underlying position trading for just $22, he knows not to worry because his put option will protect him from further declines. All he has to do is exercise the option and he can sell his shares for $23 per share, the put options’ exercise price. His maximum loss is just 4%.
Are you starting to see the value in this technique? Joe’s has a shot at 12% gains with a limited downside of just a 4% loss.
Imagine if you were using this strategy back in September before this whole financial crisis unfolded. I bet you would be sleeping a lot better these days.
Too many investors fear the options market. They believe it is too difficult to understand and the trading techniques are above their expertise. They are missing out on some powerful and safe profit opportunities.
Madoff was a great investor. He just got greedy and allowed his fund to get too large. But as a small investor, you can use the limited liquidity of the options market to your advantage.
If you have not yet used a collar strategy or any other related techniques, now is a great time to give them a try.
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December 19th, 2008 at 10:51 am
Oye Ve!!!!!!!!!!!! It keeps getting better…… this epic Ponzi scheme of Madoff (made-off) continues to fascinate the world. ….A financial holocaust… He managed to lose or steal 50 billion dollars, which can't be easy to do no matter how hard you try….. with a busy looking stock-trading operation occupying the 19th floor, of his building…. and the computers and paperwork of Bernard L. Madoff Investment Securities (his name is on the door remember!) filled the 18th floor and on the 17th floor was Bernie Madoff's fraud center, occupied by another two dozen staff members but who must have been blinded by some sort of quantitative trading wizardry in order produce that mind-numbing 10-12%… It was called the “hedge fund” floor, where the scam was conceived…….. and nobody else knew?????????????? .not the other 2 dozen employees who worked there?????? I smell rotten lox..I actually feel bad for Charles Ponzi ..Ponzi scammers will have to change their name to “Madoff schemes”.and Mr.Ponzi will disappear into the federal prison vaults……. in researching hedge funds I came across a few books that were also fascinating… Hedge Fund Trading Secrets Revealed by Robert Dorfman… and Confessions of a Street Addict by Jim Cramer….both these books take you on a great ride about hedge funds how they make and lose millions and expose many other scam practices in this game and Dorfman actually teaches his strategies.