Market Neutral Definition
Market Neutral is an investment strategy or portfolio management technique in which an investor seeks to negate (i.e. nullify) some form of market risk or volatility, by taking long and short positions in various stocks to increase his return on investment which is achieved by gaining from increasing as well as decreasing prices from one or more than one markets.
- When we purchase a stock (long position), we expect the stock price to increase so that we can sell it later at a higher price and earn the differential amount. When we short-selling (short position), we expect the stock price to decrease so that we can buy it later at a lower price and earn the differential amount.
- What if, it happens the opposite? Obviously, we have to suffer on the opposite side. The solution is pretty clear that we don’t want to suffer the opposite side. That’s where the “Market Neutral” strategy comes into play. This strategy helps you gain when the stock is decreasing (if we had taken long position) and also helps you gain when stock is increasing (if we had taken short position)
- The volatility of stock means the movement of the stock during the trade period. So, no movement means no volatility. Market Neutral strategy plays around the volatility. The basic objective is to reduce risk and not volatility. In fact, traders love volatility and there is the risk-loving world for traders or arbitragers.
Types of Market Neutral Strategies
Basically, there are two types which are as follows:
#1 – Fundamental Arbitrage
It focuses on the fundamentals of a company. It bets on the further prospects of the company. Fundamentals of a company mean the background of the managing director or chairman of the company, history of the company and its peers, financial statement analysis, possible future developments in main product of the company, growth in the Price to earnings ratio over the years, sentiments of the and many more.
#2 – Statistical Arbitrage
It focuses on quantitative methods to execute the arbitrage opportunity. It uses charts, historical data, standard deviations, current market news, etc to evaluate the “should be a price” of the stock. This helps the investor or manager to identify the undervaluation or overvaluation of a stock. It, then, executes the arbitrage opportunity to the fullest.
- The main purpose of a market-neutral strategy is to gain from all sides. The intention is to have a win-win situation for any movement that happens in the market.
- This strategy balances the short position in stocks that will underperform (i.e. loss from a stock), with long positions in other stocks that will outperform. The investment is said to be market neutral when the long positions match with short positions
- Further, the market-neutral strategy focuses on:
- Achieving “zero” beta in finance as compared to the wide market segment in which the stock is performing.
- gaining significant alpha (i.e. the difference between long and short positions) which has to be greater than the average return on the market.
How does Market Neutral Strategy work?
- Pair trading is a form of market neutral strategy. Paid trading means trading in two stocks simultaneously & it observes the correlation between two securities. Such strategies have greater importance when one stock is outperforming the market and the other is underperforming.
- Now considering any two stocks, the arbitrage opportunity is possible only when the correlation weakens in between them. Weakness in correlation means even if the stock belongs to the same industry, the individual stock prices move against the trend of that industry.
- It works best in short term market wherein one can use the moving averages (such as simple moving average, weighted moving average or exponential moving average).
- As a starting point, examine the volatility or beta of the stock with respect to the market. A beta of the stock means if market changes by, how much the stock price will change. Using the betas of individual stocks, find the amount of investment to be allocated for that stock.
- Take a long position in one stock and a short position in another stock. Each day, one will gain and others will lose and thereby, making the total “unrealized” gain at NIL. We can say a correlation of the investment to the market is zero betas.
- The question arises is “if we are gaining nothing, what is the sense in investing?”. The answer is – the investor will square off the stock in which he has gained & will continue to hold the another for favorable price. In this way, the trader or investor earn in both ways.
- But as we know, there is no free lunch in the world. The gain from such a strategy involves risk and gives smaller returns. But the good thing is, this strategy can be applied in an “n” number of times.
Example of Market Neutral
Let’s take the example of two stocks namely,
#1 – Common Information
We will take the stock data for 19th December 2019. The following charts depict the price movement during the day. We consider a simple moving average [SMA or MA] for 5 days (short term – Green Colour Line) and for 60 days (long term – Maroon color line). Let’s say we purchase i.e. Buy or go long on Dominos, and we sell i.e. go short on Papa John’s.
#2 – Chart of Domino’s Pizza
[Note: The date range used is 19th December 2019 from 9:30:00 to 15:30:00]
Domino’s: We will buy (i.e. go long for) the 1000 quantity of stock at $ 288. The total cash outflow = 288 * 1000 = $ 288,000. Since we have purchased the stock, we will have to sell the stocks later so as to square off the trade. If the stock goes up beyond 288, we will gain else we will lose.
#3 – Chart of Papa John’s Pizza
[Note: The date range used is 19th December 2019 from 9:30:00 to 15:30:00]
Papa John’s: We will short sell (i.e. go short on) 1000 quantity of stocks at $ 62. Total Cash Inflow = 62*1000 = 62,000. Since we had sold the stock now, we will have to purchase it later so as to square off the trade. If the stock goes down below 62, we will gain else we will lose.
Actual Position at the end of the day:
#4 – Calculation of Result
#1 – Domino’s Pizza:
We had gone long at $ 288 and the stock is at $ 293 i.e. we had gained $ 5 per stock. Total Gain = $ 5 * 1000 = $ 5,000
#2 – Papa John’s Pizza:
We had gone short at $ 62 & the stock is at $ 62.46 i.e. we had lost $ 0.46 per stock. Total loss = $ 0.46 *1000 = $ 460
Net Gain = 5000 – 460 = 4540
Market Neutral vs Beta Neutral
- The market (say S&P 500 Index) has a beta of 1. Beta means the correlation of stock with the market. Say, a beta of a stock is 2. It means of market moves by 1%, the stock will move by 2% in the same direction as the market. The correlation factors are explained in short below:
- Positively correlated means the stock will move in the same direction as the market. Negatively correlated means the stock will move in the opposite direction as the market moves. Zero correlation means the stock will not move in any direction.
- Beta Neutrality means zero correlation with the market. We select two stocks in which we will use the concept of market neutrality. However, we will consider the beta of stock this time. Say, Domino’s has a beta of 1.5 & Papa John’s has a beta of 2.0 and say our investment is $ 100,000.
Therefore, Investment in Domino’s = $ 100,000 * 1.5 /3.5 = $ 42,857.
Therefore, Investment in Papa John’s = $ 100,000 * 2/3.5 = $ 57,143
We can see that the investment is not the same in each stock.
- You can see that Papa John’s is more responsive to market changes. If we are bullish, we will go long for Papa John’s and short for another. If we are bearish, we will go short for Papa John’s and long for another.
- The strategy is easy to understand and implement.
- It helps reduce the general market risk to a greater extent.
- It is better than other arbitrage strategies.
- It has the least positive correlation with the market movements.
- Quick implementation and earning the profits is possible, once we know the concept.
- It is best effective when there are movements, either upside or downside. But there comes a time, when the market is flat with NIL or negligible movements.
- Since there is no free lunch, flat markets have the potential to wipe off all profits made from the market neutral strategy.
- Continuous attention is required at the market during the market hours. You cannot just deploy funds and unsee the market for a few hours. It’s different than betting for long term strategy.
- When it comes to returns from the market, one can expect an average market return which purely depends on the appropriate selection of stock, time of trading hours, the quantum of investment, etc.
- The decision to buy or sell may go wrong if optimized (i.e. stock-specific) moving averages are not utilized.
Market neutrality is helpful in the short term market. It reduces the risk to a greater extent but all the market risk cannot be eliminated. It means, this concept removes only the systematic risk, not the unsystematic risk. Hence, even after using the strategies, what actually we are exposed to is Unsystematic risk. Thus, proper selection of stock is essential before trading.
This has been a guide to market neutral and its definition. Here we discuss types, examples, and how does market-neutral strategy works along with advantages and disadvantages. You may learn more about financing from the following articles –