DEFINITION of 'Neutral'

Neutral describes a position taken in a market that is neither bullish nor bearish - in other words, it is insensitive to the direction of the market's price. 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.

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, and can be carried out using a variety of methods such as going long and short in similar stocks, and using options or other derivatives positions.

BREAKING DOWN 'Neutral'

Neutral Trends

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

If somebody goes long-shares on the weighted components of an index or index etf and then goes short on that index or etf, they have created a position that is neutral, since when the price of the index goes up so, too, will the prices of the components in an offsetting manner. But an investor may believe that there are certain structural inefficiencies between the basket of stocks that make up the index, and the index itself that may be taken advantage of. This sort of strategy can also be employed with going long and short; respectively, two companies that are very similar or are direct competitors in order to take advantage of a perceived mispricing in one versus the other. Long-short market neutral hedge funds make use of these strategies, and often use as their benchmark the risk-free rate of return because they do not worry about the direction of the market.

Neutral strategies can be constructed using derivatives such as options contracts. When buying options in the components of an index and sell options on the index itself, it is called a dispersion or correlation trade.

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.

Another neutral strategy using options is to sell a straddle or a strangle, which are short positions taken in both a call and a put of the same underlying and maturity with either the same or different strike prices, accordingly. Options called butterflies and condors are also considered "delta neutral" spread strategies.

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.

RELATED TERMS
  1. Equity Market Neutral

    Equity market neutral is a fund strategy that creates a hedge ...
  2. Cash Neutral

    Cash neutral refers to the pairing of asset purchases and sales ...
  3. Delta Neutral

    Delta neutral is a portfolio strategy consisting of positions ...
  4. Vega Neutral

    Vega neutral is a method of managing risk in options trading ...
  5. Ratio Spread

    A ratio spread is a neutral options strategy in which an investor ...
  6. Neutrality Of Money

    The neutrality of money is an economic theory that states that ...
Related Articles
  1. Trading

    Trading Volatility? Don’t Trade Stocks, Trade Options

    During times of volatility, traders can benefit greatly from trading options rather than stocks. We explain why.
  2. Investing

    Net Neutrality Could Wither Under Trump (DISH, CMCSA)

    Now that Donald Trump has won the election concerns are rising that he could do away with net neutrality.
  3. Trading

    Profiting From Position-Delta Neutral Trading

    This trading strategy will show you how to gain from a decline in implied volatility.
  4. Trading

    Option trading strategies: A guide for beginners

    Options offer alternative strategies for investors to profit from trading underlying securities. Learn about the four basic option strategies for beginners.
  5. Insights

    Does Net Neutrality Stifle Investment and Innovation?

    FCC chair Ajit Pai argues net neutrality has curbed investment, but does it?
  6. Trading

    Factors That Determine Option Pricing

    A thorough understanding of factors that affect price is essential in options trading.
  7. Trading

    Beginners Guide To Options Strategies

    Find out four simple ways to profit from call and put options strategies.
  8. Trading

    The Basics of Options Profitability

    Learn the various ways traders make money with options, and how it works.
  9. Trading

    Index Options: A How-To Guide

    Index options, financial derivatives that derive their value from a stock index, can provide stability and peace of mind for less risky investors.
  10. Trading

    Collecting Option Premium In The Grain Market

    Believe it or not, there are some great income-generating strategies that are lower in risk.
RELATED FAQS
  1. What is index option trading and how does it work?

    Learn about stock index options, including differences between single stock options and index options, and understand different ... Read Answer >>
  2. What are common delta hedging strategies?

    Learn about common delta hedging strategies, including how to make a position in options delta neutral by offsetting risk ... Read Answer >>
  3. How can derivatives be used to earn income?

    Learn how option selling strategies can be used to collect premium amounts as income, and understand how selling covered ... Read Answer >>
  4. What is the difference between a covered call and a regular call?

    Learn what a call option is, what two strategies call options can be used for, and the difference between a covered call ... Read Answer >>
Hot Definitions
  1. Business Cycle

    The business cycle describes the rise and fall in production output of goods and services in an economy. Business cycles ...
  2. Futures Contract

    An agreement to buy or sell the underlying commodity or asset at a specific price at a future date.
  3. Yield Curve

    A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but ...
  4. Portfolio

    A portfolio is a grouping of financial assets such as stocks, bonds and cash equivalents, also their mutual, exchange-traded ...
  5. Gross Profit

    Gross profit is the profit a company makes after deducting the costs of making and selling its products, or the costs of ...
  6. Diversification

    Diversification is the strategy of investing in a variety of securities in order to lower the risk involved with putting ...
Trading Center