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?
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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 trading 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 trading 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 trading is a style of trading 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 trading range. He or she will profit if
the market does not make a large move in either direction. This way of
trading 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 trading 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 trading 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 Call chooses to exercise the right. 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 trading 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 trading 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.
Gary Ang is the founder and head trader of MarketNeutralOptions.com.
Article Source: http://www.articlecity.com/articles/business_and_finance/article_7506.shtml
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