Neutral Strategies for the Novice

Market Neutral Strategies for the Novice

Neutral
Neutral Stock Market. Pixabay

Options are versatile investment tools. They can be used for both bullish and bearish strategies. But what separates options from all other investment tools is that they can also be used for neutral strategies. Those are appropriate when:

  • You do not have an opinion on market direction.
  • You believe that the markets will be relatively calm over the near term.

Let's discuss some of those strategies. Note: This article is intended for the novice options trader.

More experienced traders can find additional information by clicking the links below.


Market-Neutral Option Strategies

Important note: Unless you are a very experienced trader, always enter these orders as "spreads." A spread order tells your broker that

  • The order contains two or more different options (each option is a "leg")
  • The order requires that the broker fill all legs; not just one. By entering a spread order with two legs, you will never buy or sell only one of the legs.

If you don't know how to enter such orders, ask your broker's customer service department how to enter spread orders on their platform. 

Calendar Spread. The trader buys one option (call or put) and sells another option of the same type (i.e., call or put) with these restrictions:

  • The option bought expires after the option sold (i.e., it is "longer-dated")
  • The underlying asset is the same for both options.
  • The strike price is the same for each option.

    The longer-dated option always costs more than the near-term option. Thus, the calendar is a debit spread.

    Fact: Shorter-term options decay (i.e., lose value) more quickly than longer term options. (See Theta)

    Rationale for buying an at-the-money calendar spread: When time passes and the stock price remains essentially unchanged, the spread gains value because the option that you bought loses (or gains) value more slowly than the option that was sold.

    Therefore, the price of the spread (the difference between the price of the two individual options) increases.

    This spread is appropriate when you believe that the stock price will remain near its current level.

    Risk:

    • If the stock price moves far away from the strike price, then the spread loses money because calendar spreads are worth the most when the options are at the money.
    • When the stock price runs higher, the nearer-term option moves into the money and gains value more rapidly than the option that you own (this is due to gamma).
    • When the stock price runs  lower, the more-expensive option (the one that you bought) will begin to lose value more quickly than the less expensive option -- because that shorter-term option cannot lose much value when its price declines to near zero. 
    • [For more advanced traders: When implied volatility declines, the spread loses money because the longer-term option price is more sensitive to volatility changes. (see Vega)]

    Example of a calendar position:

       Buy 1 XYZ Nov 95 call
       Sell 1 XYZ Oct 95 call
     

    Iron Condor. This position earns a profit as time passes and the underlying stock price doesn't fluctuate much and remains within a specific price range. The position has 4 legs and it is best to enter the order as a single transaction.

    Do not attempt to trade each of the 4 legs separately.

    • Sell one (or more) out-of-the-money call option.
    • Buy one call option that is farther out of the money.
    • Sell one out-of-the-money put option
    • Buy one put option that is farther out of the money.
    • All options expire at the same time; all options are on the same stock or index.
    • Buy/sell an equal quantity of each option.
    • The call and put spreads are of equal width. Translation: The difference between the strike prices of the two call options equals the difference between the strike prices of the two put options. It does not matter how far apart the calls and the puts are from each other.

    Example: Expiration day is Aug 28, 2015.

       Sell 3 SPX Aug 28 '17 2200 call
       Buy 3 SPX Aug 28 '17 2210 call
       Sell 3 SPX Aug 28 '17 2000 put
       Sell 3 SPX Aug 28' 17 1990 put

    By selling the more expensive options, and buying less expensive options, you collect cash when trading this spread. That cash credit represents the maximum possible profit. 

    If expiration arrives and all options are worthless, then you earn that maximum profit. The options will expire worthless when expiration arrives and SPX is priced above the strike price of put sold (i.e., 2000) and below the strike price of the call sold (i.e., 2200).

    Risk
    When the underlying stock or index undergoes a larger-than-expected price change (i.e., one of the options that you sold moves into the money) it will probably cost more to exit the position than you collected when initiating the trade. In other words, the trade can lose money. The good news is that the loss is limited because the maximum cost to exit the position is 100 times the difference between the strike prices. In this example that is $1,000 per spread.

    I encourage iron condor traders NOT to wait for expiration, but to cover (i.e., close the position by reversing the original 4-legged trade) when the iron condor can be close for a small sum. The objective is to pay less when covering than you collected when making the trade. The difference in those prices, minus commissions, represents your profit (or loss).
     

    Butterfly Spread.The butterfly consists of 3 legs, and the options are all calls or all puts. Expiration day is Jan 15, 2016.

    1. Buy one option (call or put).
    2. Sell two farther out-of-the-money options.
    3. Buy one option that is even farther out of the money than the option in #2)
    4. The high- and low-strike options are equidistant from the strike price of the middle option.

    This spread is worth its maximum value when expiration arrives and the stock price is the same as the strike price of the options sold.

    Risk: the spread becomes worthless (100% of the cash investment is lost) when expiration arrives and the stock price is not between the high and low strike prices. 

    Example:

       Buy 4 XYZ Jan 15 '16 40 calls
       Sell 8 XYZ Jan 15 '16 45 calls
       Buy 4 XYZ Jan 15 '16 50 calls

     

    Each of these strategies has something to offer for the investor who believes that the markets will trade in a relatively narrow range. To see how they can be used by slightly bullish or slightly bearish investors, see this article