Tuesday, 2 February 2016

MARKET-NEUTRAL TRADING

TRADING WITHOUT A MARKET BIAS
There is a general rule that applies to option trading:
It is important to have more than a single strategy in your trade arsenal because no single strategy is appropriate for all market conditions.
Basically, there are two types of market-neutral trading, based on one of the Greeks that option traders use to risk: Gamma. Market-neutral strategies begin life with neither a bullish nor bearish bias. However, if the market moves higher or lower, they can turn into bullish/bearish positions.
1.       NEGATIVE GAMMA.
Sample strategies: Sell calls or puts; sell calls and puts (straddle, strangle), sell out of the money credit spreads.
When you own positions with negative gamma, the path to earning a profit comes from collecting time decay -- measured by the Greek, Theta -- by holding onto the position as time passes. And time always passes.
However, earning a profit is not that simple because the stock price does not always remain in a narrow area. When the price of the underlying asset (stock or index) changes by enough, then the money lost exceeds the sum earned from Theta, Why? As the stock price moves higher, negative gamma results in the position becoming short an accelerating number of Delta. In other words, your position is short in a rising market (or long in a falling market) -- and that is a money-losing situation.

2.      POSITIVE GAMMA.
Sample strategies: Buy calls or puts when you want to predict direction, or buy calls and puts (straddles and strangles) when you believe that a large price change is coming -- but you do not know whether it will be higher or lower.
Positive gamma positions are for traders who expect the price of the underlying asset to change. The greater the size of the price change, the greater the profit. However, (again) it is not that simple. Theta is working against these positions and the hoped-for price change must occur before the options lose most or all of their value as time passes.
Note that investors who adopt a buy-and-hold strategy -- who want to remain fully invested at all times -- can still find a strategy that allows them to collect Theta. They can write covered calls. But more active traders must pay attention to current market conditions and be certain that their chosen strategy is appropriate.

I trade with a market neutral bias almost all the time, for a very simplistic reason: I do not know, in advance, in which direction the market will be moving over the lifetime of the options in the position. This is especially true when trading very short-term options, or Weeklys. In addition, ‘market neutral’ is my comfort zone.
We agree that predicting the market remains a difficult game for the vast majority of traders. However, the beauty of using options is that there is an option strategy that will profit under any specific market condition -- as long as you are skilled in predicting what those market conditions will be. It is important to never get overconfident and to always trade appropriate position size because that is the first step in successful risk management.

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