Understanding Market-Neutral Trading

December 24, 2013
By Vlad Karpel

Market Volatility 02

There’s only one thing constant in the world — change. But stock markets are simply on a different level. The changes in the stock market not only happen every day or every minute, but every second!  By nature, the stock market is dynamic and unpredictable. Although, market conditions may differ from one industry to another and from one stock to the other, one thing remains: it is the fact that the market will inevitably change and even the best market analysts cannot predict stock movements with 100% accuracy.

Dilemma in a Volatile Market

As such, this volatility in the market, coupled with the uncertainty of economic conditions has often caused traders and investors to end up on the losing side.

For example, let us say that Investor A buys 1000 stocks of ABC Company, a company under the housing industry. He hoped that the stock price would rise. Then, right after the purchase, an economic crisis befalls upon the housing industry causing the stock price of ABC Company to plummet! Investor A is unfortunately in a big loss. Or, let us assume another situation, this time involving options. Investor B buys a put option of XYZ Company hoping that the stock price will fall. The stock price never falls but continues to go up until the expiration date of the option. Hence, the premium paid was lost.

In the situations above, the conditions in the market greatly affect whether an investor profits or not. Hence, investors in these situations are normally burdened to check the market conditions constantly and be vigilant on abrupt market changes because anything could just happen.

But there is a way to work around this and make some money!  Investors can make use of Market-Neutral Trading.

Market Neutral Trading Defined

Market Neutral Trading is an encompassing investment strategy that seeks to avoid some form of market risk. This is normally done through hedging.

With market neutral trading, the conditions of the market and possibility of stock price making abrupt downfalls does not prohibit a trader from earning money. In fact, a trader can even exploit the adverse or booming conditions of the market and make money. This is because market neutral trading allows an investor to profit to from the passage of time or from changes in volatility rather than from changes in the price of the underlying asset

Ways to do Trade Market-Neutral

Market-neutral strategies are often attained by matching long and short positions to increase the return from making good decisions and decreasing the return from unfavorable movements. It is important to note that there is no single way of executing a market-neutral strategy. However, the following spreads are the most popular ways to trade market-neutral using options:

1.    Condor Options – The condor option strategy is a limited, non-directional risk option trading strategy that is designed to earn a limited (but more certain) profit.



2. Neutral Calendar Straddle – The neutral calendar spread strategy involves buying long term calls and simultaneously writing an equal number of near-month at-the-money or slightly out-of-the-money calls of the same underlying security with the same strike price.




3.    Butterfly Spread – The butterfly spread is a neutral strategy that is a combination of a bull spread and a bear spread. It is a limited profit, limited risk options strategy. There are 3 striking prices involved in a butterfly spread and it can be constructed using calls or puts.

In Summary

Market-Neutral Trading is an encompassing strategy which traders like you can use to not only hedge against your potential losses but also to cushion you from the abrupt and unpredictable changes of market conditions.  There are several ways to do this but the most common ones are the Condor Options, Neutral Calendar Straddle and Butterfly Spread.

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