Market-Neutral Trading

Trading without a Market Bias

Up and Down Markets
Up? Down?. Google Images

Comment from a reader: "You mentioned that you are unskilled when it comes to picking market direction on a consistent basis. I can relate to that. But I think there are times when trading a market neutral strategy is not a wise thing to do."

Reply
I agree. There is a general rule that applies to option trading:

It is important to have more than a single strategy in your trade arsenal because no single strategy is appropriate for all market conditions.

Basically, there are two general strategies that are used by market-neutral traders. They are based on one of the Greeks that option traders use to measure risk. That Greek is Gamma, which measures the rate at which a position's Delta changes -- as the price of the underlying asset changes.

Market-neutral strategies begin life with neither a bullish nor bearish bias. However, if the market moves higher or lower, they can become bullish or bearish positions. 

  1. Negative Gamma.
    Sample strategies:Sell calls or puts; sell calls and puts (straddle, strangle), sell out of the money credit spreads.

    When you own positions with negative gamma, the path to earning a profit comes from collecting time decay. That decay is measured by the Greek, Theta, and profits accrue when the position is held as time passes. And time always passes.

    However, earning a profit is not that simple because the stock price does not always remain in a narrow range. When the price of the underlying asset (stock or index) changes by enough, then the position (i.e., the option or options that you sold) gains value and money is lost. This occurs despite that fact that time passes. In other words, the loss resulting from a price change (when that change is in the wrong direction for your position) exceeds the sum earned from Theta. When your position has negative gamma, the losses accelerate as long as the stock price moves in the same direction.. 
     
  1. Positive Gamma. 
    Sample strategies: Buy calls or puts when you want to predict direction, or buy calls and put combinations (straddles and strangles) when you believe that a large price change is coming -- but you do not know whether it will be higher or lower. Or, when you want to predict a specific direction, sell call spreads when bearing or sell put spreads when bullish.

    Positive gamma positions are for traders who expect the price of the underlying asset to change. The greater the size of the price change, the greater the profit. However, (again) it is not that simple. Theta is working against these positions and the hoped-for price change must occur before the options lose most or all of their value (due to the passage of time).
     

    Note that investors who adopt a buy-and-hold strategy -- who want to remain fully invested at all times -- can still find a strategy that allows them to collect Theta. They can write covered calls. But more active traders must pay attention to current market conditions and be certain that their chosen strategy is appropriate.

    I trade with a market neutral bias almost all the time, for a very simplistic reason: I do not know, in advance, in which direction the market will be moving over the lifetime of the options. This is especially true when trading very short-term options, or Weeklys. In addition, ‘market neutral’ is my comfort zone. You should trade according to your own comfort zone.

    We agree that predicting the market remains a difficult game for the vast majority of traders. However, the beauty of using options is that you can find an option strategy that profits under any specific market condition  -- as long as you are skilled in predicting what those market conditions will be. It is important to never get overconfident and to always trade appropriate position size because that is the first step in successful risk management.