What Is 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.

Key Takeaways

  • Neutral describes a market position that is agnostic to 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 Positions

When a security’s price goes up and down by small increments over time, it is said to be moving sideways. When a price moves sideways, the underlying security is thus in a neutral trend, moving neither up nor down over time. A neutral trend can occur after a sustained increase or decrease in price, when the price begins hitting levels of resistance or support and there is a period of consolidation. These trends can continue for days, weeks, or even months. Traders can take advantage of neutral trends through appropriate strategies that will often involve the use of short selling or derivatives contracts.

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 Trading Strategies

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.