Trading Market Neutral Strategies with Options

Most investors believe they can pick stocks that outperform the major averages, despite evidence that professional money managers cannot (see for example: Baer & Gensler, The Great Mutual Fund Trap). This may be the result of selective memory. If you are not one of those with great predictive powers, or you never know which way the stock market is going to move in the future, then the idea of trading a market-neutral strategy may appeal to you.

Market neutral strategies: The position performs approximately the same, regardless of whether the market moves higher or lower. There are two groups of strategies: One that collects when the market is calm and one that produces profits when the markets are volatile. Both begin as market neutral (without either a bullish or bearish bias).

Predicting a volatile market: Positions with positive gamma and negative time decay lose money as time passes, unless something good (a large move) happens.

1. Long straddles and strangles
2. Buy far out of the money calendar spreads
3. Own out of the money call and put spreads

Predicting a calm market: Positions with negative gamma and positive time decay earn money when the markets are stagnant.

1. Short straddles and strangles
2. Buy at the money calendar spreads
3. Iron condors (sell OTM call and put spreads)

If you are uncertain about the next market move, one of these market-neutral strategies may appeal to you. And if your expectation is for the market to be range-bound and fail to break out in either direction, that’s the time to consider market-neutral strategies with negative gamma and positive time decay.

A very popular market-neutral strategy that prospers when the markets are non-volatile is the iron condor. Read Understanding Iron Condors, Part I.

Mark Wolfinger, @MarkWolfinger, is a 20 year CBOE options veteran and is the author of the book, The Rookie’s Guide to Options.

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