Madoff Strategy Dwarfed Market in Trades ‘Never Done’ (Update4)
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By Jeff Kearns

Dec. 19 (Bloomberg) — The options trading strategy Bernard Madoff said he used to help produce profits for 17 straight years would have required at least 10 times the contracts that trade on U.S. exchanges.

Madoff, charged with defrauding clients of his $35 billion asset-management business in a “Ponzi scheme,” invested in Standard & Poor’s 100 Index companies and used options to reduce losses, according to marketing materials for his New York-based investment funds. The total number of S&P 100 options outstanding is enough to guard against losses in only $3.25 billion of trades, data compiled by Bloomberg show.

“It was never done,” Michael Schwartz, chief options strategist at Oppenheimer & Co. in New York and a trader since 1965, said of the strategy. “If he did it on an exchange, we would have heard about it, and if he did it over the counter, the person he bought it from would have hedged it on an exchange.”

The 70-year-old founder of Bernard L. Madoff Investment Securities LLC was arrested Dec. 11 and accused of running an illegal money-management operation. Federal prosecutors say Madoff admitted to stealing $50 billion from clients ranging from movie director Steven Spielberg to real-estate developer Mortimer Zuckerman. The alleged scheme ensnared investors from New York to Lucerne, Switzerland, and Bermuda.

U.S. regulators have found evidence of misconduct by Madoff stretching back to at least the 1970s, two people familiar with the inquiry told Bloomberg News.


Options traders say it should have been obvious that the firm was a fraud. Securities and Exchange Commission Chairman Christopher Cox called on Dec. 16 for a probe of his agency, saying what he has learned about its investigations of Madoff is “deeply troubling.”

“If he traded half the amount of options he claims he was, it would have been staggering when he came into the market,” said Al Greenberg, head Chicago Board Options Exchange floor trader at BNY Convergex and a former trader in the S&P 100 pit at the biggest U.S. options market. “Every index across the board would have felt tremors.”

Madoff’s firm “was not a significant player in the options industry,” said Jim Binder, a spokesman for Chicago-based Options Clearing Corp., which settles all trading of exchange- listed contracts.

‘Collar’ Strategy

Ira “Ike” Sorkin, Madoff’s New York-based attorney at Dickstein Shapiro LLP, declined to comment except to say that his client’s firm is “cooperating fully with the government.” Madoff is free on bail and hasn’t formally responded to the charges or entered a plea.

Madoff’s marketing documents said he used a “collar” strategy, which limits gains and reduces potential losses. New York-based Fairfield Greenwich Group’s Fairfield Sentry fund, which invested exclusively with Madoff, reported an average annual return of 11 percent and no down years since 1990, according to data compiled by Bloomberg.

The S&P 100 lost less than 0.1 percent to 424.18. A trade following Madoff’s strategy would involve purchasing a basket of stocks in the index, buying puts with a so-called strike price that’s less than the S&P 100’s current level, and selling calls with strikes above 424.18.

The bearish options, or puts, give the right to sell shares for a certain amount by a given date, providing protection from declines in the stock. Selling calls, which are contracts to buy, is also a bearish bet on the stock.

Privately Traded

Contracts trade publicly on seven U.S. exchanges, including the Nasdaq Stock Market. Investment firms also buy and sell options on the over-the-counter market where brokerages execute custom trades that aren’t publicly reported.

Brokers usually reduce the risk from over-the-counter transactions by making the opposite trades in public markets. The number of existing options on the S&P 100 at the end of last month would have permitted about $3.25 billion in hedges for the strategy Madoff said he used, Bloomberg data show.

The market for S&P 500 options is 58 times larger than the one for the S&P 100, with 13.8 million contracts. S&P 100 options are the 35th most-active contracts this year, while the S&P 500 ranks third, according to OCC.

“The options market, either listed or over-the-counter, could never come close to handling the trades that this guy said he was doing,” said Jim Vos, who runs the New York-based hedge fund adviser Aksia LLC. “There isn’t enough liquidity.”

To contact the reporter on this story: Jeff Kearns in New York at
Last Updated: December 19, 2008 16:44 EST