DEFINITION of 'Neutral'
Neutral describes an option on a security or market that is neither bullish nor bearish. If an investor has a neutral opinion – that is, he feels that a security or index will neither increase nor decrease in value in the near future – the investor can undertake an option strategy that may profit despite the lack of movement in the underlying security.
BREAKING DOWN 'Neutral'
Neutral market trading strategies are popular because investors can make profits when an underlying security does not move in price or stays within a tight range of prices.
When a security’s price goes up and down by small increments over time, it is moving sideways. When a price moves sideways, the underlying security is in a neutral trend. A neutral trend typically occurs after a sustained increase or decrease in price, when the price begins hitting levels of resistance or support. These trends can continue for weeks or months. Options traders take advantage of neutral trends through appropriate strategies.
Examples of Neutral Strategies
A covered call is used when an investor has an existing long position on a stock and desires returns on a neutral position. The call may provide a small amount of protection against a price decrease. If the price does not increase, the option expires worthless and the investor makes income from a stagnant stock.
A trader uses a covered put when he expects an ongoing neutral position followed by a drop in a stock’s share price. The trader writes a put option, expecting it to expire worthless and provide some profit. This is not a commonly used strategy and is unsuitable for inexperienced investors.
Pros and Cons of Neutral Strategies
Potentially profiting off stocks and other financial instruments that have been remaining relatively stable in price gives options investors more opportunities. Because many financial instruments go through long periods of staying neutral, options traders have more chances for generating returns. Also, options investors may profit off three outcomes, not just one, increasing their odds of earning profits. The maximum amount of potential profit is fixed upon the trade's execution, limiting potential profits. In contrast, options traders utilizing a strictly controlled return on investment (ROI) mandate can calculate maximum profit from the start, making income more predictable. However, because all strategies require two or more transactions, the investor pays more in commissions. Also, some strategies are complicated and unsuitable for inexperienced investors.