Profiting From Market Neutral Strategies. Part I

Bob recently inquired about how investors make money when they take a position that is neither bullish nor bearish.  The traditional method for investing in the stock market is be bullish and buy something, and hold it, as its value increases over time.

A less used method involves selling stocks short, hoping to repurchase them at a lower price, at a later date.

Market neutral strategies are seldom used by stock market investors. They may occasional try 'pairs strategies' (buy one stock in an industry and short another), but by and large investors and traders are used to making and losing money by predicting market direction.  Many don't think they are predicting, they simply get long by buying, and hope for the best.

I prefer using options to trade in a market neutral manner.  That means I don't care whether the market rises or falls, as long as it doesn't do either too strongly.  Bob want's to know how anyone can make money doing that.

There are two basic methods.  One is to trade with a theoretical edge.  That means buying options for less than they are worth and hedging, by selling options for more than they are worth.  If a portfolio built on that basis is neutral – and that means has there is no risk from market movement (gamma), time passage (theta), or a change in implied volatility (vega), then much of the time a profit is earned when the edge garnered by each trade eventually 'comes home' as option prices revalue.

This method is not for the individual trader.  it's adopted by large trading firms who have market makers on the floor of at least one exchange (or sometimes a computer replaces the market maker) and their computers are constantly analyzing the firm's holdings and then raising and lowering bids and offers to give them a better chance to buy or sell specific options that would make their entire portfolio as close to neutral (in all the greeks) as possible. 

There is another method, and that involves profiting from time decay.  I'll talk about how you, the individual trader, makes money by adopting market neutral strategies that profit from the passage of time, tomorrow.

to be continued

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