Market Neutral

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 their return on investment which is achieved by gaining from increasing as well as decreasing prices from one or more than one markets.

Investors hedge their risks by creating long and short positions which act as a hedge for one another. Hedge funds use the market neutral strategy the most as their performance metric is based on absolute returns rather than relative returns. Using this strategy, fund managers can manage any form of momentum in the market.

• Market-neutral strategies aim to generate returns by exploiting relative price movements while maintaining a neutral position in the overall market direction.
• These strategies involve pairing long and short positions in different securities or asset classes to reduce exposure to systematic risk factors.
• Market-neutral strategies seek to profit from the performance differential between the long and short positions rather than relying on the overall market trend.
• Market-neutral strategies offer potential benefits such as reduced market risk, the potential for consistent returns, and the ability to capitalize on mispricing or inefficiencies in the market.

Market neutral is a risk hedging strategy where a trader takes both the long and short positions. These positions act as a hedge for one another. The equity market neutral strategy helps traders and fund managers majorly as their returns are gauged in absolute terms.

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 the opposite happens? Obviously, we have to suffer on the opposite side. The solution is pretty clear 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 a long position) and also helps you gain when the stock is increasing (if we had taken a short position).

The volatility of stock means the movement of the stock during the trade period. So, no movement means no volatility. The market Neutral strategy plays around volatility. The basic objective is to reduce risk and not volatility. In fact, traders love volatility, and there is a risk-loving world for traders or arbitrageurs.

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.

Let us understand the purpose of using the market neutral strategy through the detailed discussion below.

• 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:
  1. Achieving “zero” beta in finance as compared to the wide market segment in which the stock is performing.
  2. We are gaining significant alpha (i.e., the difference between long and short positions), which has to be greater than the average return on the market.

Fundamentally, there are two types of equity market neutral strategies used by traders and fund managers. Let us discuss both these types in detail through the explanation below.

#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 the 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.

Depending on the risk appetite and the desired level of absolute returns from the trade, strategies can vary from one trader to another. Let us discuss and few strategies and how they work through the points below.

• Pair trading is a form of neutral market 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 that even if the stock belongs to the same industry, the individual stock prices move against the trend of that industry.
• It works best in the 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 the 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 the correlation of the investment to the market is zero betas.
• The question arises “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 other for a favorable price. In this way, the trader or investor earns 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, the market neutral strategy can be applied an “n” number of times.

Let us understand the intricate details of equity market neutral with the help of the examples below. These examples are of two extremely well-known companies in the food industry.

#1 - Common Information

Let us take the stock data for 19th December 2019. The following charts depict the price movement during the day. We consider a simple moving average for five days (short term – Green Color 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

Source: https://www.investing.com/

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

Source: https://www.investing.com/

Papa John’s: We will short sell (i.e., go short on) 1000 quantities 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 was 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

We have understood through the discussion so far that this strategy helps traders and fund managers to mitigate risks by taking long and short positions. Apart from this basic advantage, there are a handful of other advantages of adopting the market neutral strategy which has been discussed below.

• 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 are possible once we know the concept.

Despite the various advantages mentioned above, there are a few factors from the other end of the spectrum that act as a disadvantage for these players in the market. Let us discuss the downsides of equity market neutral positions through the explanation below.

• 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 neutral market strategy.
• Continuous attention is required at the market during market hours. You cannot just deploy funds and unsee the market for a few hours. It’s different from 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.

• 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 the market moves by 1%, and 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.

This has been a guide to Market Neutral and its definition. Here we explain its types, example, and trading strategies, and advantages and disadvantages. You may learn more about financing from the following articles –

• How does Trading Desk work?
• Pairs Trading
• Position Trading
• Algorithmic Trading Example