Hey Traders,
The S&P 500 (Ticker: SPX) is certainly taking us for a ride …
And if you’re still in the game (good for you – there’s massive trading opportunities out there right now!) you might be wondering if there’s anything you can do to help reduce some of the massive volatility and risk out there right now.
The answer, of course, is ABSOLUTELY.
Reducing your directional risk might be easier than you think …
And by trading “market neutral” you can actually set yourself up to win from BOTH sides of the market!
“Market neutral” trading is more or less exactly what it sounds like – it’s structuring your trades to profit regardless of market direction.
How is that possible? After all, isn’t trading all about speculating on where the market is heading next?
Yes and no.
Yes, most traders do trade directionally. Most of the simplest, and easiest trades to make are directional – think about buying a call, versus opening a butterfly spread.
More traders will be more comfortable with the outright, simple trades … but that doesn’t mean they are the only way to make money … and they’re certainly not necessarily the best!
Instead, you can set yourself up to take advantage of market movement in both directions …
Or, in the case of some spreads, you can profit from no direction, such as with a short straddle, where you sell a call and a put at the same strike, hoping for minimal movement from the underlying.
Market neutral strategies can be used as a hedging tool, but I use them as outright profit mechanisms.
There’s lots of ways to trade market neutral, but we won’t go over every single market neutral trading strategy today (since there are too many, and they can be quite complex).
What is important to know is that typically, a market neutral strategy involves going both long and short on the market (or a sector or equity) so that you’re able to profit from both a move higher (thanks to your long position) and/or a move lower (thanks to your short position).
In options, this might look like a straddle or a strangle (where you are buying or selling both a call and put), or another “complex” spread (and don’t be intimidated by the world “complex” – they’re usually easier than you think!).
There are also more “creative” ways to trade market neutral … for example, you could open S&P 500 (Ticker: SPX) calls, and pair them with Cboe Volatility Index (Ticker: VIX) calls.
Why would that be market neutral?
The SPX and VIX are usually inversely correlated. Since VIX measures demand for SPX options, when the SPX is rallying, the VIX is typically dropping, and when the SPX is dropping, demand for SPX options rises, boosting the VIX.
Take a look at this comparison of the SPX (top) and VIX (bottom) to see what I mean:
So by buying calls in both, you are (in theory) setting yourself up to profit if the SPX rises (thanks to the straight SPX calls) or falls (thanks to your VIX calls).
There’s other indices I like to pair against each other to take advantage of market movement, and it’s also possible to play certain sectors against one another, or even by trading certain stocks against one another to profit from sector-wide headwinds or tailwinds.
However, spreads are by far the market neutral strategies I use the most … and they often work out quite well for me.
They also have added benefits like helping me reduce the overall cost of a trade, manage my risk, and use other factors of the options pricing model (like volatility) to target profits as well.
So let’s take a look at how you can set yourself up to profit in both directions using spreads …
I’m going to take a look at a trade I recently closed out in my Nitro Trader program.
I took aim at SPDR Euro Stoxx 50 ETF (Ticker: FEZ). It had just seen a pretty solid uptrend, and I was betting it would continue moving … but I wasn’t totally sold on the rallying continuing.
So, my Nitro Traders and I bought one FEZ April 40-strike call for $0.65, so we would be ready to profit if FEZ did resume its journey higher …
At the same time, we also opened the FEZ 39/35/31-strike put butterflies – which means we purchased the 39-strike put and 31-strike put (the wings) and sold twice as many of the 35-strike puts (the “body”).
(Butterflies are really not as intimidating as you might think, and they’re one of my all-time favorite trade types. Get a rundown on them here.)
In a long butterfly trade, you want the underlying to end up as close to the “sold” strike as possible, so this trade would see maximum profits with FEZ at $35.
So we’ve got a relatively low-cost call to profit from upside over $40, and a risk-controlled, low-cost butterfly to help us profit from potential downside starting at $39 (of course, we didn’t even need FEZ to actually drop below $39 or move above $40 – a move in either direction would increase the value of our options, allowing us to profit).
Over the next few days, FEZ started to decline pretty hard, increasing the value of our put flies to $1.05!
Yes, this meant that our calls ended up worthless … but remember, we would have been able to profit in either direction, so that’s the trade-off.
(Sometimes if you’re lucky, you’ll see movement in both directions, allowing you to cash out each side separately and profit from both!).
Overall, this trade gave us a solid +53% gain – not bad considering the market conditions we’ve been seeing, and considering we were ready to win in BOTH directions!
Or, if you’re interested in taking your trading to the next level – setting yourself up to profit by playing the market in multiple directions, and limiting your risk – my Nitro Trader program is currently offering reduced-cost quarterly memberships right here.
Do you trade market neutral? What are some of your favorite “win-win” trading strategies to use? Let me know in the comments!
Your Only Option,
Mark Sebastian