Introduction to Market-Neutral Options Trading
Any monkeys can make money in a bull market. Most stocks rise in a bull market, buy (long) any stock, wait for the prices to rise and then sell. A classic example of “buy low sell high.”
Some smarter monkeys can also make money in a bear market. Since most stocks crash in a bear market, simply sell (short) any stock, wait for prices to fall and then buy back to cover. A case of “sell high cover low.” Sounds simple enough isn’t it?
How does one make money in a market that is neither bullish nor bearish? A market that moves up a bit on one day and falls the next day is also called a side-way market; it is not moving up, neither is it moving down.
The fact is that markets, especially indices such as the S&P 500 (SPX), Dow Jones Industrial Average (DJIA) and the NASDAQ Composite (COMP) very rarely have large moves that last for months.
While it is true that these indices generally increase in value over time, it is usually over a long period of time. Most of the time, these indices are in a range.
For example, the DJIA has not been able to change by more than 5% either up or down from one option expiration to the next for 70% of the time since the beginning of 2002. Like wise, the NASDAQ Composite has not changed by more than 9% over 80% of the time.
Since the market is generally within a range for most of the time, it will be rather difficult for traders with a directional bias to consistently profit from the market.
The key to consistent profit is to adapt a market-neutral strategy when the bulls and bears are fighting it out.
What is Market-Neutral Trading?
Simply put, market-neutral is a style of whereby the trader has no directional bias—he or she is market-neutral. This approach is often confused with delta-neutral trading, which is quite a different beast altogether. For our purpose, we’ll just stick to discussing market-neutral trading.
When a trader is market-neutral, he or she is speculating that the market will stay within a range. He or she will profit if the market does not make a large move in either direction.
This way of is very rewarding and is extensively used by professional market makers because it is a lot easier to predict the range that the market will trade than to predict a bull or bear market. In short, there is a higher probability that the market will trade within a range.
How does Market-Neutral Strategies Make Money?
While nobody can predict the market, there are certain aspects of the market that traders can see correlations and make a judgment based on his or her own analysis.
Some traders rely on fundamental analysis, which requires them to scrutinize the company’s annual reports to make a value judgment for his or her investments.
Others rely on technical analysis, which requires them to search for buy or sell signals from the charts.
All in all there are many styles of that traders employ. Some adopt a contrarian’s approach while others utilize a combination of all.
The market is a place where traders with different perspectives and expectations meet and therefore, it is highly unpredictable.
But one thing remains constant in the chaos. Time passes.
Options are decaying assets, upon expiration, only options that are in-the-money (ITM) have intrinsic value. In fact, most options expire worthless. It is based on this time-decay element that market-neutral strategies make money.
Since out-of-the money (OTM) options will become worthless on expiration, we can sell OTM options before they become worthless and when they do become worthless, we’d have pocketed the money that we collected when we sold the options.
All market-neutral strategies work under this principle. However, to sell a naked option requires a huge margin and is also very risky because it exposes the option seller to unlimited risk.
For example, let’s say SPY is at 130 and you sell a SPY 132 Call for $0.60. Now, since buying a Call gives you the right to buy the underlying at the strike price, when you sell a Call, you sell someone the right to buy the underlying at the strike price from you. When you sell a Call you are obliged to deliver the underlying at the strike price if the buyer of the
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In this example, you receive $60 for the Call you sold. If SPY expires below 132 on expiration, the 132 Call you sold expires worthless and you get to keep the $60 credit.
However, should the SPY expires at 134 on expiration, the call you sold will be worth $2.
Now, you have two choices: first, you can choose to cover (buy back) your short Call by paying $2 and incur a ($2–$0.60 = $1.40) $1.40 loss; or second, be assigned, where you have to buy the underlying at the current market price of $134 and deliver it to the buyer of your Call at $132 thereby incurring a loss of ($2–$0.60 = $1.40) $1.40 loss.
Either way you suffer a loss of $1.40. The higher SPY goes, the higher your loss. That is why brokerage firms usually require a huge margin for this type of unlimited risk positions. Some brokerage firms don’t even allow retail traders to enter such positions.
Professional traders do not usually sell naked options and responsible ones discourage retail traders to use it. Professional traders prefer to limit their risk by hedging against that naked position. They sell a spread.
Spreads
Selling a credit spread is to go short (selling) an option with a higher value and go long (buying) an option with a lower value.
A basic vertical Call spread involves selling a Call option with a lower strike and buying another Call option with a higher strike. You could sell a SPY 133 Call and buy SPY 134 Call. Now you are no longer selling a naked Call.
For example, SPY is currently at 130.68. A SPY 133 Call is worth $1.15 while a SPY 134 Call is worth $0.80. A vertical Call spread would be to sell the 133 Call at $1.15 and buy the 134 Call at $0.80 for a $0.35 credit.
Sell 133 Call at $1.15 You sold someone the right to buy the stock from you at $133.
Buy 134 Call at $0.80 You purchased the right from someone else to buy the stock at $134.
Net received $0.35 You have limited your risk to $0.65. ($1 – $0.35 = $0.65)
If SPY is below 133 on expiration day, both the options become worthless and the trader keeps the $0.35 credit he or she received.
However, if SPY rallies to 135 on expiration, the short 133 Call will be worth $2 while the long 134 Call will be worth $1. He or she will have to cover (buy back) the short 133 Call at $2 and sell the long 134 Call at $1 to close the position if he or she does not want to be assigned. In that case, he or she would have made a $0.65 (the $1 difference minus the initial $0.35 credit) loss. Even if the SPY goes up to 140, he or she still only suffers a $0.65 loss.
This spread is commonly known as Credit Call Spread, Short Vertical Call or Bear Call Spread. When you sell a Call Spread, you don’t want the stock to move up. It is therefore a bearish instrument.
The opposite (Credit Put Spread, Short Vertical Put or Bull Put Spread) works the same way.
For example, SPY is currently at 130.68. A SPY 128 Put is worth $1.00 while a SPY 127 Put is worth $0.80. A vertical Put spread would be to sell the 128 Put at $1.00 and buy the 127 Put at $0.80 for a $0.20 credit.
Sell 128 Put at $1.00 You sold someone the right to sell the stock to you at $128; you are obliged to buy the stock at $128 from the person you sold the put to.
Buy 127 Put at $0.80 You purchased the right from someone else to sell the stock at $127.
Net received $0.20 You have limited your risk to $0.80. ($1 – $0.20 = $0.80)
If SPY is above 128 on expiration day, both the options become worthless and the trader keeps the $0.20 credit he or she received.
However, if SPY crashes to 125 on expiration, the short 128 Put will be worth $3 while the long 127 Put will be worth $2. He or she will have to cover (buy back) the short 128 Put at $3 and sell the long 127 Put at $2 to close the position if he or she does not want to be assigned. In that case, he or she would have made a $0.80 (the $1 difference minus the initial $0.20 credit) loss. Even if the SPY goes down to 120, he or she still only suffers a maximum of $0.80 loss.
This way of selling options is more prudent than selling naked options without any hedge. You receive less credit (because you have to buy a hedge) than selling the naked option outright but you have also limited your risk. The trade-off is well worth it.
The vertical spreads are the basic building blocks of market-neutral strategies such as the Iron Condor. Vertical spreads can also be used for directional plays since selling a Call vertical spread is bearish and selling a Put vertical spread is bullish, one can sell a Call spread in a bear market and a Put vertical spread in a bull market.
Essentially vertical spreads make money by generating positive theta (the Greek for time decay).
To learn more about Market-Neutral Options Strategies such as the Iron Condor and Double Diagonal, go to www.marketneutraloptions.com.
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Gary Ang is the founder and head trader of MarketNeutralOptions.com.
