There Is No Such Thing As A Free Option!--At Least For Any Length Of Time!

In this week's Barron's, there is reproduced almost in entirety an article written in 2001 raising questions about Bernie Madoff. (By the way, what a great name for a swindler who "made off" with other people's money!) In it, there is a description of Madoff's strategy as a "split-strike conversion". This involves the purchase of an underlying stock, the purchase of an out-of-the-money put option, and the sale of an out-of-the-money call option. Upon reading this, I started to reminisce....

More than a quarter of a century ago, I was drawn to an arcane form of hedging using listed options. As I have mentioned in a previous posting, I am risk averse, and was attracted to the original concept of a hedge fund, which attempted to beat the market with less than a market risk. The Chicago Board Options Exchange ("CBOE") began trading in the early 1970's, and The American Stock Exchange ("AMEX") started to trade options a few years later. Many of the options traders on the CBOE were used to hedging due to their having traded on the Chicago Mercantile Exchange. Due in part to this "hedging mentality" the options traded on the CBOE became efficiently priced very quickly--that is, they traded at or close to their theoretical value as determined by complex formulae using integral calculus, such as the Black-Scholes model. The traders on the Amex, however, were by and large speculators who "didn't know from theoretical values". This allowed disciplined hedgers to take advantage of option price inefficiencies. One could go long an underpriced option and short a less underpriced option in a ratio of options sold to options bought that was "market neutral", wait until the two prices became closer to theoretical values, then close out the position for a profit. This activity is known as option spreading.

I rented an AMEX options seat and started trading in these spreads. As a market maker on the floor, I could trade with very little margin and almost no transaction costs. A retail client of an options trader could not compete with a market maker of equal skill due to the above advantages. The commissions alone would eat up the profit potential.

I started making some money, and raised capital from several people who knew me from the past. During this period, I could put the spreads on without any time elapsing between transacting the long and short positions. This was a form of arbitrage--which is the simultaneous or nearly simultaneous purchase and sale of equivalent securities for profit.

The window of opportunity for making money in this comparatively riskless way was quite brief. After all, money is fungible. If a casino allowed a bet whose payoff exceeded the odds of winning, so much money would flow into that bet that the casino would be bankrupt very quickly. In the case of AMEX option trading, the best bridge, chess, and backgammon players in the country descended on the AMEX floor to become market makers. After all, many of these people were "bridge bums" who made a paltry living playing their game for money or were hired by lesser players to win tournaments for them. My first hedge fund experience was as a junior general partner in a fund managed by a very famous bridge player, who was then in his sixties. He hired as a "gofer" one of the best young bridge players in the country. A few years later, that gofer started trading options on the AMEX, made a small fortune, and then staked some of his bridge buddies, and made a large fortune.

With the onslaught of these games players, the AMEX option market became efficient. One could establish juicy spread positions only by "lifting a leg", which required estimating which way the underlying stock was going, taking half the spread immediately,, and the other half after time elapsed. This increased the risk of options hedging and required short-term trading skills that I did not possess. I shut down my options firm and returned the capital to my investors.

Now let's discuss the "split-strike conversion" strategy purported to be Madoff's way of generating those consistent, high returns for his accounts. A "conversion" refers to transforming a put into a call. Long stock and long put is mathematically
equivalent to long call. So Madoff allegedly created a call with a lower strike price than the call he sold. Sound familiar? That is simply a call option spread.
Given that those spreads became pretty efficient, either Madoff was prescient in "lifting a leg" or he was very good at trading around his position once it was established, or both. While it is mathematically possible to achieve those impressive returns, the probability of doing so is de minimus given the fact that Madoff charged his clients commissions. Even if Madoff were the world's best trader and the fiftieth best trader were a market maker with far less friction costs, that market maker would have had Madoff for lunch. And this doesn't take into account the amount of money that can be profitably managed this way. Certainly, $17 billion leveraged would be a stretch!

My take on Madoff is that he started out generating excellent returns, but found that increasingly difficult to achieve legitimately. He then turned to more nefarious strategies.