To understand market-neutral strategies, we first need to understand the directional bias of call and put options.
When I buy a call option, I'm betting that the stock will move higher.
When I sell a call option, I'm betting that the stock will move lower or at least not go above the strike price I chose.
Similarly, when I buy a put option, I'm betting that the stock will move lower.
And when I sell a put option, I'm betting that the stock will move higher or at least not go below the strike price I chose.
Market-neutral strategies are formed by choosing pairs of options whose directional bias cancels out.
For example, let's say a stock trades at $51 and I buy a call and a put on that stock, both with a $51 strike price and the same expiration date.
This creates what's known as a straddle trade, which is market neutral.
When I initiate this trade, I benefit from downward and upward market direction equally. Therefore, I am market neutral.
But since I bought both a put and a call, I need the stock to move in order to make money.
This is what the payoff graph would look like if each option cost me $0.50.
Source: TradeSmith
The blue line represents the payoff at expiration based on the stock's price.
As you can see, I need the stock to move more than $1 in either direction in order to turn a profit. This is to make up for the premium I paid to own the options.
On the flip side, if I sold both a call and a put option with a $51 strike and the same expiration and collected a $1 credit, my payoff graph would look like this.
Source: TradeSmith
You can see that I want the stock to move absolutely nowhere. If that happens, I get to keep the $1 premium I made from selling the options.
Both of these are examples of market-neutral strategies. The difference is that the first one needs price movement to turn a profit, while the second one wants the stock to remain where it is.
Key Point: There are two types of market-neutral strategies: long and short.
Long strategies need the stock to move in any direction to turn a profit.
Short strategies need the stock to remain where it is in order to turn a profit. Movements up or down in share price work against the trader. Plus, the amount of money you have to set aside to cover a short market-neutral trade isn't any higher than the greater of the buying power requirements between the call or put option.
For example, if I sold a cash-secured put with a $15 strike price on a stock that currently trades at $15, I would be required to set aside enough cash to purchase 100 shares of that stock at $15, or $1,500. However, I can sell a $15 call option on that same stock and not have to put up any more capital (in many cases). Each broker's capital requirements for a trade can differ.
Market-Neutral Strategies
Now that you understand what market-neutral strategies are, let's cover a list of some of the more popular ones.
Straddle: You buy or sell a call and a put with the same strike price and the same expiration. The strike price should be the stock's current price or as close as possible.
Long straddle: The stock trades at $51. I pay a premium to buy the $51 call and $51 put. I want the stock to move higher or lower by more than the amount I paid to initiate the trade.
Short straddle: The stock trades at $51. I sell the $51 call and $51 put to collect a premium. I want the stock to remain at $51.
Strangle: As with a straddle, you buy or sell a call and a put with the same expiration. However, you do this with out-of-the-money options.
Long strangle: The stock trades at $51. I pay a premium to buy the $55 call and $46 put. I want the stock to move above the call strike or below the put strike by more than the amount I paid to initiate the trade.
Short strangle: The stock trades at $51. I sell the $55 call and $46 put and receive a credit. I want the stock to remain above the put strike and below the call strike by expiration. That way both options expire worthless and I get to keep the credit I received when I initiated the trade.
Iron Condor: This is a lot like a strangle. The only difference is that you buy or sell another call or put option that's further out of the money than the first option.
Long Iron Condor: The stock trades at $51. I buy the $55 call and then sell the $56 call. Then I buy the $46 put and sell the $45 put. I pay a debit to initiate this trade. I want the stock to move above both call strikes or below both put strikes to achieve maximum profit.
Short Iron Condor: The stock trades at $51. I sell the $55 call and then buy the $56 call. Then I sell the $46 put and buy the $45 put. I receive a credit when I initiate this trade. I want the stock to remain between the inner strikes through expiration. That means all the contracts expire worthless and I get to keep the credit I received when I initiated the trade.
There are multiple variations of these trades, including iron flies, butterflies, and calendar spreads. However, they all stem from some version of these trades.
There is one key piece of information that I use to determine whether I want to go with a long or short market-neutral options strategy: implied volatility.
We've talked about implied volatility a lot because it's critical to creating an edge when trading options.
Implied volatility is the market's demand for options. High implied volatility increases the price of options. Low implied volatility decreases the price.
And implied volatility is mean-reverting. That means the further away implied volatility moves from its historical average, the more likely it is to snap back.
So…
When implied volatility is HIGH, we want to go with SHORT market-neutral options strategies.
When implied volatility is LOW, we want to go with LONG market-neutral options strategies.
Now that you understand the basics of market-neutral strategies, which is your favorite and why?
While I can't answer you individually, I promise to read every email.
Enjoy your Wednesday,
Keith Kaplan CEO, TradeSmith
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TradeSmith is not registered as an investment adviser and operates under the publishers' exemption of the Investment Advisers Act of 1940. The investments and strategies discussed in TradeSmith's content do not constitute personalized investment advice. Any trading or investment decisions you take are in reliance on your own analysis and judgment and not in reliance on TradeSmith. There are risks inherent in investing and past investment performance is not indicative of future results.
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