beginners corner

Bernie Madoff Revisited

Oh no, not another Bernie article! Sorry folks, I couldn’t resist. I have such an interest in this story on so many levels. Madoff was claiming to use a strategy related to covered call writing. The Madoff whistleblower, Harry Markopolos, was involved with a covered call strategy when Bernie was dumped on his lap. I have been focused in on watching the regulatory agencies since the Enron, Tyco and Worldcom debacles and especially as more and more retail investors have joined the BCI community. Finally, I wonder, how does a mind become so demented that one would hurt so many people, friends and relatives included, to generate money that you don’t need and will never, ever be able to spend?

Harry Markopolos was a derivatives expert, a quant as he calls himself, a specialist in quantitative analysis. He was working for Rampart Investment Management Company employing a covered call strategy when his superior asked him the following question: We’re losing too much business to this Madoff guy, why can’t you duplicate what he’s doing? This was more of an order than a request. Madoff claimed to be using a split strike conversion strategy where he would buy multiple baskets of 30-35 stocks correlated to the S&P 100 (not 500). He would then sell out-of-the-money calls and buy out-of-the-money puts on the index. The calls funded the puts. He claimed to adjust his bullish or bearish bias by adjusting the strikes of the options by overweighting or underweighting one or the other. In other words, he was market timing, something no one else can do successfully over the long haul. Bernie’s statements showed his investors that he always went into cash before the market turned down. He was a true miracle maker.

Bernie Madoff- miracle maker

First Harry had to see Bernie’s results to know what he was to accomplish. Much to his shock and surprise Madoff was showing smooth annual returns of 15-16% per year with no monthly loss greater than 55 basis points. Plus, no volatility! If the market was down, Bernie wasn’t. If the market was up, so was Bernie. Ultimately Madoff showed small losses in only 4 of 139 consecutive months. Investors were begging him to take their money, no questions asked. 

Harry the quant felt that if Bernie could do this so could he. The more he ran the numbers, the more he failed to achieve these results. Rampart considered him a failure; Harry took exception and was motivated to get to the bottom of this. He developed a team of experts that couldn’t be stopped because they knew that Bernie was a fraud…people lie, numbers do not.

There were a myriad of institutional investors who couldn’t understand these results as well. Bernie was secretive about his formula. He claimed a proprietary “black box” system that gives him trading signals which led to his uncanny success. That was good enough for the “big boys”. Keep generating those returns King Bernie! They had to know something was up but chose to look the other way. Harry and company did not.

Team Markopolos came to the conclusion that there were only two possible explanations:

1- Bernie was front-running or using his broker-dealer business to view large trade orders to then place trades first in his hedge fund operation. This is illegal and would hurt his broker-dealer clients and benefit his hedge fund members. Most of the institutional players thought that this was in fact what Bernie was up to but chose to look the other way as they became richer and richer on paper. Harry felt that this was possible but unlikely to accomplish as he estimated that Madoff was handling more than $7B at that time.

2- Bernie was running a Ponzi scheme. This is a fraudulent operation that pays returns to separate investors, not from any actual profit earned by the fund, but from their own money or money paid by subsequent investors. After tireless investigation Harry was convinced that he needed to notify the SEC that the revered Bernie Madoff was a liar, a cheat and the developer of the world’s largest and most dangerous Ponzi scheme. He feared for his life, for his family’s safety, for his job security as he wondered just how powerful was this Madoff guy and how could he be getting away with this fraud? There was no stopping Harry…go ahead, make my day.

Harry Markopolos....make my day

Harry felt that when he brought proof to the SEC, Bernie’s goose would be cooked:

  • 2000: Approached the Boston office of the SEC with proof of a Madoff ponzi scheme
  • 2001: A second submission to the Boston office
  • 2005: A third submission to the Boston office
  • 2008: Sent an email submission to the SEC’s Office of Risk Management

Here were some of the “red flags” he described to the SEC:

  • He settled for much lower fees than average hedge funds…why?
  • Too much secrecy
  • There were not enough listed call options to generate the income on the assets held by BM
  • The math does not support 4 monthly losses in 139 consecutive months
  • Why is he claiming to trade over-the-counter, more expensive options unless there is a need for secrecy
  • Why have Goldman and Citi declined to invest with Madoff?
  • It is mathematically impossible to trade over the long term and have low correlation with the market
  • It is impossible to have perfect market timing
  • He doesn’t allow outside performance audits
  • Only Madoff family members are privy to his investment strategy (the ole’ black box)
  • He always goes to 100% cash on December 31st making for cleaner financial statements…a known red flag for fraud.

Harry’s submissions were ignored time and time again. The SEC failed to protect the investors it was directed to shelter. Another $50B + was lost because Harry was ignored. Incredible! Sad! _________you fill in the blank!

Why was he ignored time and time again? Harry hypothesized that it could be corruption, incompetence, ambivalence or failure to believe that the great BM could be involved in anything fraudulent. Since he never found any definitive signs of corruption, it was probably a combination of the other three with an emphasis on incompetence.

With the collapse of the financial and real estate markets in 2008, investors needed to access their money from Bernie but there was no money there. Ponzi schemes depend on the constant flow of new money and Bernie’s prayers for a miracle were not answered. The hopes and dreams of many good and innocent people were lost; charities could no longer do their good work, Bernie’s son committed suicide as did a French hedge fund manager and Madoff is spending what is left of his life in jail. Incredibly he feels sorry for himself and still is justifying his actions.

The only explanation:

A lack of empathy towards others that is coupled with the display of abnormal moral conduct and inability to conform with the norms of the society.  Stealing, lying, lack of remorse for others and towards living beings, irresponsible behavior, impulsive behavior,  problems with the law, violating rights of others, aggressive behavior and much more. This is the definition of a sociopath.

The SEC is now working to become a functional and meaningful agency to protect the folks. Progress has been made in this area. Harry and his team are heroes. They are earning honest livings with their families intact and free to be assets to our society. Bernie has lost a son because of his actions. He has no friends. What’s left of his family has no contact with him as he spends the rest of his life in prison. All over money that he just didn’t need.

Some things in life I’ll never understand….this is one of them.


What is parity?

An option is said to be trading at parity when the the option has no time value and so its price consists solely of intrinsic value. For example, if a stock is trading @ $35 and the $30 call is priced @ $5, it is trading at parity.


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Market tone:

Economic reports continue to support the notion of a slowly improving economy:

  • The unemployment rate dropped 0.1% in February to 8.9%, the lowest level since April, 2009.
  • The ISM reported an increase in factory activity for the 19th consecutive month.
  • Orders for manufactured goods rose a better-than-expected 3.1% in January.
  • The Federal Reserve’s Beige Book survey showed a continued recovery but at a slow pace.
  • The ISM also reported the service sector now at its highest level in six years.
  • Construction spending dropped 0.7% in January.
  • Personal income rose 1% in January which resulted in more savings, not spending.

For the week, the S&P 500 was up 0.1% for a year-to-date return of 5.5% including dividends.


IBD: Uptrend under pressure

BCI: Cautiously bullish selling an equal amount of I-T-M and O-T-M strikes. Recent volatility due to global issues is the main reason for the caution.

My best to all,

Alan ([email protected])


About Alan Ellman

Alan Ellman loves options trading so much he has written four top selling books on the topic of selling covered calls, one about put-selling and a sixth book about long-term investing. Alan is a national speaker for The Money Show, The Stock Traders Expo and the American Association of Individual Investors. He also writes financial columns for both US and International publications along with his own award-winning blog.. He is a retired dentist, a personal fitness trainer, successful real estate investor, but he is known mostly for his practical and successful stock option strategies.

44 Responses to “Bernie Madoff Revisited”

  1. owen March 5, 2011 6:28 pm #

    The S.E.C. missed the Madoff scheme for a very simple reason. They were watching porn on their computers eight hours a day. Watching Bernie and his clients just looked like another porn movie to them.

  2. Gary March 6, 2011 7:36 am #


    Great article and summary of this sad part of our history. I know a few people who invested with Madoff and their lives have been ruined. Keep up your good work.


  3. Barry B March 6, 2011 8:46 am #

    Premium Members,

    The Weekly Report dated 3/4/11 has been uploaded to the premium area,



  4. Bruce March 6, 2011 11:45 am #


    I am a new member and printed out today’s report. On the first two pages a few letters of the ticker symbols were cut off. Any suggestions?



  5. admin March 6, 2011 12:23 pm #


    This issue has come up with a few of our members:

    1- Go to “print”
    2- Properties
    3- Page scaling
    4- Fit to printable area

    That should do it.


  6. owen March 6, 2011 12:46 pm #

    There is actually another type of fallout from Bernie’s scheme. He had a legitimate trading company that was completely on the up and up. Several of his former bond traders are tax clients of ours. They earned in the upper six figures and were completely honest. They can’t get a job that requires a prospective employee to list his job history.

  7. Evan March 6, 2011 6:47 pm #

    A terrific article!

    The American Dream was plugged into our minds when we were kids. This dream gets carried away.

    Madoff was an SEC supporter and helped the SEC numerous times. It’s no wonder they ignored the complaints.

    When people make money greed takes over and those people don’t want to know the truth.

    Corruption, greed and poor education plagues our world. Terrorists can’t be changed as they are programmed in school starting at 5 years old. Bernie took the American Dream that he learned about way too far.

    Hell, I want to make money too but sometimes the drive to help others and the drive to roll in the dough are at odds with each other. It’s not easy for people to guard against the impulse to roll in the dough.

    I am not sure if Bernie is a sociopath. He cried for weeks about his son who committed suicide and expressed remorse which is likely fake but may have an atom of truth.

    Interestingly he says that our gov’t is a giant ponzi scheme. I think he is right.

    We borrow from important programs and the first investors get paid. I have a feeling the scheme will unfold when the gov’t can’t pay the rest of the investors.

  8. Preston March 6, 2011 9:54 pm #

    Why does Apple always fail Fundamental Analysis in he premium report? The SS number is 10, but I never see an explanation. Can someone give me some insight?


    I am showing Healthspring’s Histogram just below one, and signal line crossing downward on the MACD, yet it still passed? Am I doing something wrong?



  9. admin March 6, 2011 10:28 pm #


    AAPL is a great stock, no doubt. However, it does not pass our SmartSelect screen which requires ALL six green circles. The Accumulation/Distribution ranking is “D” and red and therefore fails. This is a technical reason for elimination and is reflected at the bottom of page 1 of the premium report. Admittedly, our screens are quite demanding but it is our hard-earned money we are investing.

    HS shows a beautiful price chart as set up in figure 28, page 85 of “Cashing in on Covered Calls”. See the chart I just constructed below with the highlights of the chart. You can click on the chart to enlarge it and then use your back arrow to return to this page.


  10. Dave March 7, 2011 7:12 am #

    Great article Alan! Damn your a good writer…

  11. Barbara March 7, 2011 8:09 am #

    Wonderful article Alan. I must admit feeling anger as I read it but broke into a belly laugh with your “make my day” line.



  12. owen March 7, 2011 3:16 pm #

    A little light reading from Harry Markopolos, No One Would Listen. Good book.

  13. Bruce March 7, 2011 4:10 pm #


    When you say that you avoid stocks with high volatility are you referring to historical or implied? Sorry if this question has already been answered.


  14. owen March 7, 2011 4:58 pm #

    Is it just me, or does that “Executing a Covered Call” screen give you an image of a stone wall, a post, a blindfold and a cigarette?

  15. admin March 7, 2011 5:21 pm #


    When using the covered call strategy we consider both types of volatility:

    1- We consider historical volatility depending on our assessment of market tone. That is why we include “beta” in our premium reports. High beta stocks tend to outperform the market in bullish scenarios and low beta stocks outperform in bearish markets.

    2- IV tells us the market assessment of projected volatility for that particular contract period. If we see a 10% 1-month return for an A-T-M strike, the IV is extremely high and the market is anticipating a huge price move of the underlying in EITHER direction. We should avoid these situations. Earnings reports are an example of such situations.



    Not that type of “executing” but thanks for the much needed humor.


    Many thanks for the on and off site remarks for this week’s article. I appreciate your support. It was actually motivated by the news of Goldman insider trading and Madoff’s New York magazine article where he tried to justify his crimes..ughhh.


  16. Amy March 8, 2011 8:09 am #


    What guuidelines do you use when deciding between high and low beta stocks?



  17. admin March 8, 2011 1:16 pm #

    Email tax question from Tom:

    Dear Alan,

    I have enjoyed both of your books, and continue to regularly read articles on your web site. I know you have indicated that writing options within a retirement account (Roth IRA, etc) is preferable from a tax perspective, however, I was wondering if there was some way to create a similar effect in a non-retirement account by structuring an LLC or a corporation. The reason I ask, is that Hedge Funds and Private Equity Firms seem to be able to convert ongoing income into capital gains (15% tax rate) and also seem to be able to defer some income and allow it to compound before having to pay taxes. I am not sure how they accomplish this, but I was wondering if any of their techniques could be applied to reduce the additional tax created by writing options in a non-retirement account?

    I confirmed the following response with Owen Sargent ([email protected]):

    The short answer is … no. Hedge fund managers have an unusual treatment for their interest in the hedge fund that allows them to treat their income as long term capital gain. Congress is hot after changing that, too. The investors in the hedge fund get income passed through to them in the nature it was earned. Short term gain is short term gain, interest income is interest income, etc.

    A small investor who creates an LLC or an S-corporation is going to get all of the income passed through as the same type that is earned. It does not provide any advantage and actually creates additional expense because you have to file a return for the entity.

    Thanks to Tom for an outstanding question and to Owen for his expertise in this area.


  18. admin March 8, 2011 1:49 pm #

    Amy (#16),

    First let me say that beta is a secondary consideration the fundamental, technical and common sense screens inherent in the BCI system. We added beta information to the premium report as an enhancement to tweek our returns a bit higher.

    If we are in a full blown bull market I will favor O-T-M strikes and high beta stocks because the odds predict a more favorable outcome. If we are in a volatile and slightly bearish market I will favor I-T-M strikes and low-beta stocks. We can never be right 100% of the time but by throwing the odds in our favor over and over again, we will be right much more often than wrong.


  19. admin March 8, 2011 2:26 pm #

    Who can find a flaw in this strategy?

    I had the following email inquiry that I felt many could benefit from:

    “My thought is that if I bought 100 shares of ROK and open a short position of 100 shares of ROK and sold a covered call then I am protected against a decline and I am also limited in my gains of the call minus commissions. My thought is that I could profit from the highest extrinsic value option with 100% downside protection”.

    I admire and respect when our members think outside the box. Can you find a flaw in this strategy?


  20. Fred March 8, 2011 4:11 pm #

    Check out PPO. Looks like a good stock with good returns.

  21. Mark T. March 8, 2011 4:44 pm #

    Re #19

    A couple of months ago we had a discussion of trying a similar theory with inverse index ETF’s. I spent some time backtesting it and could never get it to work. It sounded good in theory but due to slippage etc it didn’t work.

    I’ll sleep on it and see what I can come up with.


  22. admin March 8, 2011 4:58 pm #

    # 19 (hint):

    Calculate your three positions (long stock, short stock and short call) if on expiration Friday the short call is:

    1- in-the-money
    2- out-of-the-money
    3- at-the-money

    I thought this would be an interesting exercise to show how we might evaluate covered call-related strategies.


  23. owen March 8, 2011 6:08 pm #

    I don’t need to use #22 choices of 1, 2 or 3 to calculate the flaw in #19.

    #19 has a major flaw. You are trying to use the same 100 shares of stock to cover the short call position AND the short stock position. If the stock rises you risk an infinite loss on the short stock or the short call. Nice try, though.

  24. TonyH March 8, 2011 6:09 pm #


    I re-read your first book, and noticed in the back were “email alerts” that seemed very in depth and informative. In other words, you seemed to provide a little more of your thought process when making some of your decisions. Is this blog the email alert substitute or are there still emails alerts we need to sign up for?

  25. Mark T. March 8, 2011 6:20 pm #

    Alan & Owen

    So we are really selling a naked call then?


  26. admin March 8, 2011 6:31 pm #


    Exactly. For newbies going through the process of different ending prices relative to the strike would be an excellent exercise.


    If we buy and short sell stock for $40 and sell the $45 call for $3, we have an initial profit of $3. But what if the stock ends the contract period @ $50? Our short call will be exercised and our shares sold. Now we are short the stock which we sold for $40 and will have to replace @ $50, a $10 loss. If the stock keeps appreciating in value our losses will increase. When a stock is shorted, we are borrowing it from our broker and must replace it at current market value. Shorting (by itself) is a strategy that some sophisticated investors use when they anticipate a stock price to decline. They may short sell a stock @$40, collect the $40 per share and then replace at a lower price. This is not a good strategy for conservative investors.


  27. owen March 8, 2011 6:33 pm #


    You would either be selling a naked short call, or selling a naked short stock position. You say toeMAYtoe, I say toeMAHtoe, you’re still naked for 100 shares with the sky being the limit. Just don’t do it with NFLX, GOOG or PCLN without telling me. I’ll take the other side of the trade.

  28. admin March 8, 2011 6:38 pm #


    The email alerts you see in my first book were sent prior to the development of the Blue Collar website and before I started writing weekly articles with commentary. It was the precursor of the website you see today. If you have any specific suggestions or ideas you would like to see The BCI team makes every effort to respond to the needs of our members.


  29. owen March 8, 2011 6:39 pm #

    Alan is correct. If you sit down and work it out on paper, hopefully, you will realize that you have a disaster in the making. It is important that you learn to see what will happen if the stock rises, falls, or stays the same, EVERY TIME.

    Don’t just look at a trade and say to yourself, “Bought it at $38, sold the $40 call for $1.50. I’ll make $3.50 when it gets called away.”

    You MUST look at what will happen if the stock drops to $30, rises to $50, or just sits there and spins like a top at $38.

  30. admin March 9, 2011 8:45 am #


    Recently bounced back and now passes our SmartSelect screens. Boasted a 14% positive 4th quarter earnings report in February with revenues up 24% and a bullish growth projection of 18%. It is strong financially with $129M in cash and no long-term debt. Despite its recent price increase DECK is reasoably valued with a PEG jusy slightly above 1. Check to see if this stock deserves a spot on your watch list.


  31. Todd March 9, 2011 8:57 am #


    In your DVDs you mention that deltas run between 0 and 1 but I have seen deltas with negative numbers. What am I missing?



  32. admin March 9, 2011 9:37 am #


    The delta of a call ooption is always a positive number between 0 and 1 or 0 and 100 for percentile format. Where you see a negative sign in front of a delta it is related to a put option where the option value runs in the opposite direction from that of the underlying.


  33. Jim March 9, 2011 1:38 pm #

    Has anyone out there had any success implementing a dividend capture strategy using covered call writing with deep in the money calls?


  34. Jorge March 9, 2011 7:56 pm #


    I haven’t used this strategy but came across this Cramer article that may interest you:

    Good luck.

  35. Phil March 10, 2011 8:14 am #

    I recently discovered this site and I’m new to options. Can anyone tell me if we should be checking the option delta when we sell a call. I’ve read that delta is important to all option traders. Thanks for your help.


  36. Fred March 10, 2011 11:56 am #


    My understanding is that delta and the other greeks are important if you trade naked options but maybe Alan can clarify this.


  37. Andy March 10, 2011 12:40 pm #

    Hi Alan,

    I’m a new member and I’m curious to hear your opinion on a few thoughts I’m mulling.

    1) With the relatively big daily market swings recently, it occurs to me that, at the beginning of a cycle when you are establishing your initial positions for the coming month, if you should have the bad luck to enter many positions on day that is followed by a couple of down days, your whole next month could be facing an uphill battle. What do you think about reducing risk by entering the positions over several days instead? This would also forfeit a bit of time premium capture, of course.

    2) Maybe it’s just my bad luck, but I’ve already closed several losing positions this cycle and most of my open positions are in the red. I’m wondering if being exposed for the full month is too big a risk? Since the most time premium decay occurs in the last 2 weeks of a cycle, would it make sense to wait a bit and not enter positions until there are 2-3 weeks remaining?


  38. admin March 10, 2011 2:48 pm #

    Phil and Fred (#s 35 and 36),

    As a covered call writer I do NOT believe that it is necessary to look up the Greek values for an option. This is more important for those dealing with naked options or those looking to hedge a portfolio. I will be addressing these matters in future articles as I have been receiving more inquiries about these scenarios. One can never have too much education.

    That being said, understanding the concepts of the Greeks and how they relate to stock and strike selection IS important. For example, knowing that the delta of an in-the-money strike can approach 1 makes it easier and less costly for us to unwind a position should the stock price decline in value. Look for more journal articles relating to the Greeks in the near future.


  39. admin March 10, 2011 2:58 pm #

    Andy (#37),

    Most options traders love volatile markets. Conservative covered call writers do not.

    1- Entering positions over time can work for or against you and time value will be lost. If you wait and enter a position after a large “up day” this may subject you to the risk of profit-taking. In volatile markets I prefer to enter I-T-M positions to get a decent premium along with downside protection. Here you have to be willing to deal with no upside potential.

    2- I prefer to enter my positions in the first week of a 4-week contract or within the first 8 trading days of a 5-week contract. This is my comfort level. Remember, our obligation is only 1 month. You may want to paper trade different time frames and strikes to find the right approach for your risk tolerance.

    Recently the market has become more volatile in the short term and I tend to favor I-T-M strikes until the market calms.


  40. Bill March 10, 2011 3:19 pm #


    Can you explain why a delta of 1 makes it easier to close a position. I am new to options and apologize if this question is too basic or has already been answered.

    Thank you


  41. admin March 10, 2011 8:54 pm #


    When you sell an I-T-M call with a delta near 1, the option price will drop close to dollar-for-dollar with the stock making it less costly to close (buy back) the option. O-T-M stocks have low deltas and as the stock price drops the option price declines at a slower pace making it more expensive to close your short position.

    Thanks for your question and participating in our blog.


  42. admin March 10, 2011 9:44 pm #

    Premium members:

    This week’s report of top-performing ETFs has been uploaded to your premium site. New members: if you didn’t receive a direct email notifying you of this upload, please let us know and we’ll add your name to the premium mailing list. Premium members, who have changed their email addresses and do not receive direct emails, send your updated address to:

    [email protected]

    For your convenience, here is the link to login to the premium site:

    Alan and the BCI team

  43. Fred March 11, 2011 12:25 pm #

    I have heard that a stock price will decrease by the amount of a dividend. Does the option value also decline by that amount?



  44. admin March 11, 2011 1:27 pm #


    You are correct in that a stock price will decrease by the dividend value when the stock goes “ex-dividend” and this is already incorporated into the option pricing. However, if a dividend is increased, the price of the stock will decline by a greater amount and the option value will decline based on the delta of that option. For example, if a dividend is raised by $0.50 and the delta of the option is .5 (usually for an at-the-money strike), the option value will decline by $0.25. The opposite can be said if a dividend is decreased.


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