What Is Neutral?
Let me explain what neutral means in trading. Neutral describes a position in the market that's neither bullish nor bearish—it's insensitive to the direction of the market's price. If you believe a security or index won't increase or decrease much in value soon, you can use an option strategy to profit even without movement in the underlying security.
These neutral market trading strategies let you make money when a security doesn't move in price or stays within a tight range. You can achieve this by going long and short in similar stocks or using options and other derivatives positions.
Key Takeaways
- Neutral is an agnostic position in terms of price movements and so is neither bullish nor bearish.
- Sideways markets or other neutral trends can be taken advantage of through neutral trading strategies.
- The use of derivatives such as delta-neutral options positions can achieve a neutral portfolio.
Understanding Neutral
When a security’s price fluctuates by small increments over time, it's moving sideways. In this case, the security is in a neutral trend, not going up or down significantly. This can happen after a big price increase or decrease, when it hits resistance or support levels and consolidates. These trends might last days, weeks, or months.
You can take advantage of these neutral trends with strategies involving short selling or derivatives. For example, if you long shares in the weighted components of an index or ETF and short the index itself, you've created a neutral position—price moves in the index will offset with the components.
You might see structural inefficiencies between the index's stocks and the index that you can exploit. In a dispersion trade, you bet half the index components rise and half drop on a trading day, but the index overall doesn't move much.
Another approach is taking a long position in one company and short in a similar one or competitor to capitalize on mispricing. If Coca-Cola and PepsiCo stocks correlate highly, and Pepsi surges while Coke doesn't, you short Pepsi and long Coke, expecting the price spread to normalize—this is a pairs trade.
Long-short market-neutral hedge funds use these strategies and benchmark against the risk-free rate, since they ignore market direction.
Neutral Trading Strategies
You can build neutral strategies with derivatives like options contracts. For instance, buying options on index components and selling on the index itself is a dispersion or correlation trade.
A covered call works if you already have a long position in a stock and want returns from a neutral stance. The call offers minor protection against price drops. If the price stays flat, the option expires worthless, and you gain income from the stagnant stock.
You might use a covered put if you expect a neutral position followed by a price drop. You write a put option, hoping it expires worthless for profit. This isn't common and isn't for inexperienced investors.
Selling a straddle or strangle involves short positions in a call and put on the same underlying with the same expiration, possibly different strikes. Butterflies and condors are also delta-neutral spread strategies.
Warning
These strategies can be complicated and are unsuitable for inexperienced investors.
Advantages and Disadvantages of Neutral Strategies
You can potentially profit from stocks and instruments that stay stable in price, giving you more opportunities as an options investor. Since many instruments remain neutral for long periods, you have more chances to generate returns.
Options investors can profit from three outcomes, not just one, boosting your odds. But rewards are limited, with maximum profit fixed at trade execution.
If you follow a strict ROI mandate, you can calculate maximum profit upfront, making income predictable. However, all strategies involve multiple transactions, so you pay more in commissions.
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