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
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.