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—believing that a security or index will neither increase nor decrease in value in the near future—they can undertake an option strategy that may profit despite the lack of movement in the underlying security.
Neutral market trading strategies enable investors to make money when an underlying security does not move in price or stays within a tight range of prices. This can be achieved using a variety of methods, such as going long and short in similar stocks and using options or other derivatives positions.
- 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.
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 often involve the use of short selling or derivatives contracts. If somebody longs 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.
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 can be taken advantage of. For instance, in one neutral strategy called a dispersion trade, a trader can bet that half of the index components will rise in a trading day and the other half drop—but the index itself does not move much as a result.
A neutral trading strategy can also be employed by simultaneously taking a long position in one company and a short position in a second company that is very similar or a direct competitor in order to take advantage of perceived mispricing. So, if Coca-Cola and PepsiCo have a high correlation in the movements of their respective stock prices, and then Pepsi's stock suddenly surges while Coke does not, a trader may short Pepsi and go long Coca-Cola, betting that their existing price-spread relationship will be restored. This is known as a pairs trade.
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 in 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.
- Traders use a covered put when they expect 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 security and expiration date and either the same or different strike prices. Options called butterflies and condors are also considered "delta neutral" spread strategies.
These strategies can be complicated and are unsuitable for inexperienced investors.
Advantages of Disadvantages of Neutral Strategies
Potentially profiting off stocks and other financial instruments that have remained 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.
In addition, options investors may profit off three outcomes, not just one, increasing their odds of earning profits. Rewards aren't, however, limitless as the maximum amount of potential profit is fixed upon the trade's execution.
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.