Market neutral investing is, simply put, making bets on change instead of direction. Those who buy a stock say, “it will go up”. Those who short a stock believe it will decline in value. Those are directional trades. A market neutral trader knows how to make a bet that a stock will stay the same or a bet that a stock will change. In either case, there is no directional bias.
Betting on change
1. Buy a straddle. Purchase a put and a call at the same strike price, usually as close to the stock price as possible so that you can buy it cheaply. If the underlying moves in either direction, one of your options will be in the money. The hope is that one of the options increases in value enough to make up for the fact that the other is worthless.
2. Buy an iron condor. Basically, when you buy an iron condor, you buy a straddle and sell two lower valued options to offset the cost. Technically, an iron condor will not usually have the put and the call sold at the same strike, but the idea is the same. If the stock price goes outside a certain range, your position will be more valuable that it was when you bought it.
Why is it good to bed on change? You can have a fairly high probability of profit, and you don’t have to take a bullish or bearish stance on a stock. It’s really all about emotions, but then everything in life is. For some reason, it feels less risky to make a directionless bet. In reality, you can still lose since the underlying can stay where it is. However, if you feel more confident and comfortable you’ll make better decisions and therefore be a more successful trader.
What’s the catch? High options prices! If a stock has been very volatile, the options will be overpriced. Everyone knows that the stock will probably change, everyone wants to buy straddles and iron condors. People are afraid the stock will go down and they own it, so they buy a put. They think it will go up and they don’t own it, so they buy a call. You won’t get your position cheaply, and the underlying will have to change a lot before you make a profit.
Betting against change
1. Sell a straddle. (Hey, I never said this article would be sophisticated!)
2. Sell an iron condor.
In either case, you hope that the underlying will stay where it is and time decay will work in your favor. You sold those options when they were overpriced, so as long as neither the put nor the call goes deep in the money, you’ll make a profit.
In the case of the straddle, you sold the put and call at the same strike, so one will be in the money. Period. You’ll either need to buy back the in the money option before expiry or allow yourself to be assigned. If the underlying hovers right at the strike price, you may want to buy back both the put and the call when they get cheap enough. I hate dealing with stock and assignment, so I like to be on the safe side that way.
If you sold the iron condor, you hope the underlying stays in between the put strike and the call strike. Realistically, this is not likely if you got a good credit for your iron condor. To get a decent credit, you have to sell fairly near the money. You will probably have to make adjustments using condors or butterflies as time goes on. (I call it flapping the wings on my iron condors.)
If you sold an iron condor and one wing goes very bad, you may want to use a vertical role to move it into the next month. Keep in mind though; you just turned it into a directional trade! If you want to keep it market neutral, you can roll both wings or sell another vertical in the back month.