Jeffrey McLarty

Algorithmic & Actively Managed Market-Making Buy-Write is what I call the strategy and it’s my latest way I’m going to harvest money from the capital markets without having to worry too much. It’s more like an experiment in liquidity. My intentions are to test out my hypothesis, prove it works, then open up a fund to friends and family to invest privately.

For starters, to understand what I’m doing, you have to know what a “buy-write” is. If you do, skip this paragraph.  A Buy-Write is a strategy where you go long an asset, and write derivatives against your ownership.  The most common form, is going long the stock and writing calls.  The beauty behind it is you go long an asset you don’t mind holding anyway. Ie, you wouldn’t sell it if it became cheaper but for the right price you’d be happy to sell it (higher).  Well, you choose what price you’d “be happy to sell for” and write that call.  You rake in anywhere between 1/2 % to 2 % a month, hopefully while your stock goes up in value (but not too quickly).  This strategy is arguably less risky than un-hedged ownership because once you write the calls, the asset can fall in value a little, and you’re free to take profit on the calls fall in value.  So, while the upside is capped (while you’re covered), and the downside is a hypothetical -100%, you offset you’re P/L line with the premium of the derivative.

Market making is the act of always trying to sell or buy something, it adds liquidity to the market, and the goal is to capture the bid/ask spread.

My strategy is merging these two ideas to get a Market Making Buy-Write.  I’m going to manage if actively adding compensation for bullishness and bearishness, and I’m working on an algorithm to do it for me.

So, I’ll go long (at least 1000 shares) of a double-long options trading ETF.  The higher the implied volatility, the better, and the more bullish you are on it, the better. I’m going to use HXU.TO, double long the TSX - because I believe Canada is in good shape, compared to other countries. I’m also going to apply the same strategy to SSO.  I’m less bullish on the US, but IV is higher…so it’s a wash.  And I’m also going to do it with one other diversified emerging market ETF.

This is how it mechanically…

1. Go long the ETF (BTW, this will work with regular stock too, but stocks swing more violently and IV is less consistent); Eg. HXU.TO at ~$30, at least 1000 shares = $30K.

2. Send 3 to 5 orders to sell various call options on either the front-one,-two, or -three month option (out of the money). Wait patiently, if the markets move up, raise the ask, if it falls, lower the ask. The options are so illiquid, it might take a week for an order to take.

3. Any that are sold, immediately try to buy them back cheaper, trying to capture the bid/ask spread, patiently waiting at the bid. If the markets move up, good, if they don’t, time is on your side and you’re covered. More patient waiting.

4. Repeat 2 and 3 as much as possible.

There is an active/human based management component, where watching the markets full time, one can incorporate short-term bearish/bullishness into the strategy by picking different strikes and being more or less willing to sell calls (aka raise or lower the ask/bid accordingly). But it’s important to always be ready to sell/buy calls - for the right price.

Downfalls to this strategy are that volatility can blow it apart. Luckily as volatility climbs, so should option premiums. The TSX could shoot up, but in which case, any stock covered will just get called away and return more that capturing the spread would have. Of course, there’s a downside, but it should be offset by the fact that any short calls will fall in price, and in the long-run the market trends up.

Starting out, over the next three months, I’m going to program an algorithm using Interactive Broker’s API to do exactly what I’ll be doing manually to test this out. After I have the algorithm working, I’ll add in some bullish/bearish constants that I can change whenever I feel like and leave it on auto-pilot.

Here we have a strategy, that even if with 1000 shares, if you can sell 5 calls, and buy them back $1 or more cheaper, once a month - you’ll have a machine that’s generating at least $500 / $30K = 1.6% per month = 22% per year (before taxes) while the asset should easily appreciate by at least 15% year.

I’m curious about the scaling of this idea, but as time goes by, liquidity will improve. So, as liquidity improves…I’ll shoot for 15 contracts a month taking $0.3 each time, rather than the 5 contracts taking $1 each time.

This strategy is nothing new, people have been doing it since options started trading, I’m just going to get my slice of the pie.