Neutral Trading Strategies

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Neutral Trading Strategies

Neutral options trading strategies are employed when the options trader does not know whether the underlying stock price will rise or fall. Also known as non-directional strategies, they are so named because the potential to profit does not depend on whether the underlying stock price will go upwards or downwards. Rather, the correct neutral strategy to employ depends on the expected volatility of the underlying stock price.

Bullish on Volatility

Neutral trading strategies that profit when the underlying stock price experience big moves upwards or downwards include the long straddle, long strangle, short condors and short butterflies.

Bearish on Volatility

Neutral trading strategies that profit when the underlying stock price experience little or no movement include the short straddle, short strangle, ratio spreads, long condors and long butterflies.

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Buying Straddles into Earnings

Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

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Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

Neutral Market Trading Strategies

A major reason why trading options is so popular is because of the number of opportunities there are for making profits. For example, unlike other forms of investment, options give traders the chance to profit when an underlying security remains neutral i.e. it doesn’t move in price.

This function is unique to options, because there are no other financial instruments that can be traded to generate profits from a lack of price movement. There are a large number of neutral options trading strategies (also known as non-directional strategies) that can be used when you have a neutral outlook on an underlying security, and if you can gain a good understanding of these then you will open up many opportunities for making profits.

On this page we explain the concept of a neutral trend and discuss the advantages and disadvantages of using neutral trading strategies. In addition, we provide a list of strategies that you can use to profit from a neutral outlook.

  • What is a Neutral Trend?
  • Advantages of Neutral Strategies
  • Disadvantages of Neutral Strategies
  • List of Neutral Strategies

What is a Neutral Trend?

In investment terms, the word neutral is generally used to describe a financial instrument that doesn’t move in price. While this is technically accurate, in the context of options trading the word has a slightly broader meaning. When we talk about neutral trading strategies, we are talking about strategies that not only profit from an underlying security staying at the same price but also profit when that security moves within a tight range of prices.

When the price of a security goes up and down by small amounts over a period of time, it’s said to be moving sideways. This is because if you plotted the price movements on a graph, the graph line wouldn’t show any real incline or decline, but it would basically be moving sideways. When a price is moving sideways the underlying security is in what’s known as a neutral trend.

During such a trend the price of the underlying security is consistently going up and down, but not usually by a huge amount and it’s always remaining with a certain range. A neutral trend will typically occur after a sustained increase in price or a sustained decrease in price when the price starts hitting levels of resistance or support accordingly.

These trends can continue for weeks or even months at a time. Stock traders and other investors will really struggle to profit under these circumstances and they will typically leave securities that are in a neutral trend alone. However, options traders can take advantage of them by using appropriate strategies.

Advantages of Neutral Strategies

The biggest advantage of neutral options trading strategies is really the simple fact that they exist. Being able to profit from stocks and other financial instruments that remain relatively stable in price gives investors who use options many more opportunities than those who don’t.

Many financial instruments go through prolonged periods of being neutral, or in a neutral trend, and this gives options traders plenty of chances to generate returns. It’s somewhat obvious that the more potentially profitable opportunities there are, the greater the chance there is of being successful on a consistent basis.

The other main advantage of these strategies is that by using them you can profit from three different outcomes. If the underlying security doesn’t move at all, you will make a profit. If the underlying security increases in price or decreases in price, you will still make a profit, providing the price movements stay within an appropriate range.

Some strategies need the price of the underlying security to remain in a very tight range to return a profit, while others can profit from a wider range. To some extent, you can control just how wide you want the range to be and this is another example of just how flexible options trading can be.

Other advantages include the fact that you can turn time decay into a positive and also control your risk exposure to some extent. When using some of the more basic strategies, it’s very simple to work out the maximum potential profit and maximum potential loss, and this can be very useful for when planning trades and managing risk.

Finally, the fact that there are so many different strategies you can use means you have plenty of choice and a good chance of finding one that fits well with your personal objectives.

Disadvantages of Neutral Strategies

There isn’t many major disadvantages when it comes to using strategies of this type. The biggest drawback is the fact that the potential profits of these is always limited, because the maximum amount of profit that can be made from any trade is essentially fixed at the moment it’s executed.

Another disadvantage is that the strategies all require at least two transactions, and some of them more, so you will potentially pay a fair amount in commissions. This is actually true of most options trading strategies. Also, some of them can be quite complicated and certainly not suitable for beginners.

These disadvantages are all relatively minor though, and it should be clear that they are far outweighed by the benefits.

List of Neutral Strategies

Below, we have listed a range of neutral options trading strategies that are commonly used by options traders. We’ve included a little information about each one, but for further details you should click on the relevant link. If you are struggling to choose a suitable strategy, you may like to take a look at our Selection Tool.

This is relatively simple and would typically be used if you already own a security and want to profit from it being in a neutral trend. It’s suitable for beginners.

This is fairly simple and you would generally use it if you already own a security and want to profit from it being in a neutral trend and protect it against any losses should it fall in price. It is suitable for beginners.

This is reasonably complex and combines short selling a security and writing put options. It’s not suitable for beginners.

This is a relatively simple trading strategy, but it’s not really suitable for beginners due to the high trading level required. It involves two transactions and creates a credit spread.

This is quite straightforward but requires a high trading level so it’s not suitable for beginners. It creates a credit spread and involves two transactions.

This combines two transactions to create a credit spread. It’s quite simple, but it requires a high trading level meaning it isn’t suitable for a beginner.

This is simple enough to be used by beginners. Two transactions are involved and a debit spread is created.

This is straightforward and involves two transactions. It creates a debit spread and is suitable for beginners.

This is a complicated trading strategy that is not suitable for beginners. There are two transactions involved and a credit spread is created.

This is complex and not for beginners. It creates a credit spread with two transactions.

This involves four separate transactions to create a debit spread. It isn’t suitable for beginners.

This creates a debit spread. There are four transactions involved and it isn’t suitable for beginners.

This is complex and involves three transactions to create a debit spread. It isn’t suitable for beginners.

This is complex and it creates a debit spread using four separate transactions. It isn’t suitable for beginners.

This involves four transactions and is complicated. It creates a debit spread and is not suitable for beginners.

This is complex and creates a credit spread. It involves four transactions and it’s not suitable for beginners.

This is complex, involving four transactions, and it’s not suitable for beginners. It creates a credit spread.

This is complicated and not suitable for beginners. It involves four transactions and creates a credit spread.

Market Neutral

What Does Market Neutral Mean?

A market-neutral strategy is a type of investment strategy undertaken by an investor or an investment manager that seeks to profit from both increasing and decreasing prices in one or more markets, while attempting to completely avoid some specific form of market risk. Market-neutral strategies are often attained by taking matching long and short positions in different stocks to increase the return from making good stock selections and decreasing the return from broad market movements.

Market Neutral Explained

There is no single accepted method of employing a market-neutral strategy. Beyond the method mentioned above, market-neutral strategists may also use other tools such as merger arbitrage, shorting sectors, and so on. Managers who hold a market-neutral position are able to exploit any momentum in the market. Hedge funds commonly take a market-neutral position because they are focused on absolute as opposed to relative returns. A market-neutral position may involve taking a 50% long, 50% short position in a particular industry, such as oil and gas, or taking the same position in the broader market.

Often, market-neutral strategies are likened to long/short equity funds, though they are distinctly different. Long/short funds simply aim to vary their long and short stock exposures across industries, taking advantage of undervalued and overvalued opportunities. Market-neutral strategies, on the other hand, focus on making concentrated bets based on pricing discrepancies with the main goal of achieving a zero beta versus its appropriate market index to hedge out systematic risk. While market-neutral funds use long and short positions, this fund category’s goal is distinctly different than plain long/short funds.

The Two Main Market-Neutral Strategies

There are two main market-neutral strategies that fund managers employ: fundamental arbitrage and statistical arbitrage. Fundamental market-neutral investors use fundamental analysis, rather than quantitative algorithms, to project a company’s path forward and make trades based on predicted stock price convergences. Statistical arbitrage market-neutral funds use algorithms and quantitative methods to uncover price discrepancies in stocks based on historical data. Then, based on these quantitative results, the managers will place trades on stocks that are likely to revert to their price means.

A great benefit and advantage of market-neutral funds is their big emphasis on constructing portfolios to mitigate market risk. In times of high market volatility, historical results have shown that market neutral funds are likely to outperform funds using other certain strategies. Except for pure short-selling strategies, market-neutral strategies historically have the lowest positive correlations to the market specifically because the place specific bets on stock price convergences while hedging away general market risk.

Example of a Market Neutral Fund

Because it is a market-neutral strategy, the Vanguard Market Neutral Investor Shares fund uses long and short-selling strategies, unlike the firm’s other mutual funds, which only buy and sell long positions. The fund’s strategy aims to minimize the impact of the stock market on its returns, meaning the fund’s returns may vary widely from those of the market.

Although most funds that short stocks, such as hedge funds, do not disclose their short holdings because SEC rules do not require them to, the Vanguard Market Neutral Investor Shares does publish its shorts. It chooses short positions by evaluating companies by five categories: growth, quality, management decisions, sentiment, and valuation. Then, it creates a composite expected return for all of the stocks in its universe and shorts those with the lowest scores.

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