I've been doing some research into how Bernie Madoff fooled investors, and I've discovered that he pitched a scheme known as split-strike conversion. Apparently it's a legitimate investment strategy. I understand that one of the appeals of spilt-strike conversion is that it minimizes risk by diversifying an investor's portfolio. My question is, how would I utilize this investment strategy in my own investment portfolio?

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As an aside. an interesting aspect of the split-strike strategy that Madoff claimed he was using was that Harry Markopolos - a financial analyst and portfolio manager - was asked by his boss to duplicate Madoff's strategy. Markopolis observed that the open interest in the options in the S&P 100 stocks that Madoff claimed to be buying did not exist and that Madoff had to be a fraud. He brought this to the attention of the SEC which only made a cursory examination of Madoff's fabricated trade confirmations and statements, and Madoff's Ponzi Scheme survived for almost another 10 years.

The split-strike conversion strategy is more commonly known as a long stock collar. It typically involves selling an out-of-the-money (OTM) call and using the proceeds to buy an OTM put for every 100 shares that you own. This defines a floor beneath which you cannot lose as well as a ceiling, beyond which you will not profit.

I do a lot of collars and when the market cratered in March, the long puts protected me nicely. For example, I owned 1,000 shares of DOW which I bought at $44 and had a $40/$50 collar on. It dropped to about $22 and the puts appreciated to $18, meaning that I was never down more than $4. I'll spare you the explanation of how I managed the position but with some adjustments along the way, I generated gains long before DOW recovered back to $44. I still own a few other stocks that are currently trading for 1/3 to 1/2 less than what I paid for them yet I only have modest losses due to having collars on them.

Collars can be structured for no cost. If you want to skew the risk graph so that you have more upside potential than downside risk, the short call should be further OTM (or the put closer to the money), resulting in a net cost for the collar. Skewing the collar in the opposite manner (the put is further OTM than the call is OTM) will result in a net credit but the potential loss will be greater than the potential profit.

Pending dividends affect option premium. They inflate put premium and deflate call premium. Therefore, the larger the dividend, the more expensive a collar will be. This isn't a bad thing. I only mention it because you need to account for the dividend in your calculation of cost and ROI.

If you do 1-3 month collars and the stock appreciates toward the short call strike, you may be able to roll the collar up and/or out, protecting some of your capital gain as well as raising your upside potential. Wash, rinse, repeat.

Caveat? Don't monkey with collars if you don't want to sell the stock.

Collared long stock is synthetically equal to a vertical spread. That means that they have similar performance and similar risk graphs. Since the vertical involves fewer legs, it may incur less slippage and fewer commissions (if you're still paying them).

  • Thank you for that detailed explanation! That gives me a better understanding of how long stock collar mitigates risk. Aug 14, 2020 at 5:28

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