Market Neutral Definition How Does This Strategy Work

Market Neutral Definition

Explanation

When we purchase a stock (long positionLong PositionLong position denotes buying of a stock, currency or commodity in the hope that the future price will get higher from the present price. The security can be bought in the cash market or in the derivative market. The course of action suggests that the investor or the trader is expecting an upward movement of the stock from is prevailing levels.read more), 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-sellingShort-sellingShort Selling is a trading strategy designed to make quick gains by speculating on the falling prices of financial security. It is done by borrowing the security from a broker and selling it in the market and thereafter repurchasing the security once the prices have fallen.read more (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 a long position) and also helps you gain when 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. 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 a risk-loving world for traders or arbitrageurs.

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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 the main product of the company, growth in the price to earnings ratio To Earnings RatioThe price to earnings (PE) ratio measures the relative value of the corporate stocks, i.e., whether it is undervalued or overvalued. It is calculated as the proportion of the current price per share to the earnings per share. read more over the years, sentiments of the and many more.

#2 – Statistical Arbitrage

It focuses on quantitative methods to execute the arbitrageThe ArbitrageArbitrage in finance means simultaneous purchasing and selling a security in different markets or other exchanges to generate risk-free profit from the security’s price difference. It involves exploiting market inefficiency to generate profits resulting in different prices to the point where no arbitrage opportunities are left.read more 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 stockOvervaluation Of A StockOvervalued Stocks refer to stocks having more current market value than their real earning potential or the P/E Ratio. Overvaluation of stocks might occur due to illogical decision making or deterioration in a Company’s financial health. read more. It then executes the arbitrage opportunity to the fullest.

Purpose

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 financeBeta In FinanceBeta is a financial metric that determines how sensitive a stock’s price is to changes in the market price (index). It’s used to analyze the systematic risks associated with a specific investment. In statistics, beta is the slope of a line that can be calculated by regressing stock returns against market returns.read more as compared to the wide market segment in which the stock is performing.We are gaining significant alpha (i.e., the difference between long and short positionsLong And Short PositionsThe term “long position” refers to the purchase of securities or commodities with the expectation of making profits. In contrast, when a trader takes a short position, he or she sells securities or commodities with the intention of repurchasing them later at a lower price.read more), which has to be greater than the average return on the market.

How does Market Neutral Strategy work?

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 averageMoving AverageMoving Average (MA), commonly used in capital markets, can be defined as a succession of mean that is derived from a successive period of numbers or values and the same would be calculated continually as the new data is available. This can be lagging or trend-following indicator as this would be based on previous numbers.read more, 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 a 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, this strategy can be applied an “n” number of times.

Example of Market Neutral

Let’s take the example of two stocks, namely,

Achieving “zero” beta in financeBeta In FinanceBeta is a financial metric that determines how sensitive a stock’s price is to changes in the market price (index). It’s used to analyze the systematic risks associated with a specific investment. In statistics, beta is the slope of a line that can be calculated by regressing stock returns against market returns.read more as compared to the wide market segment in which the stock is performing.We are gaining significant alpha (i.e., the difference between long and short positionsLong And Short PositionsThe term “long position” refers to the purchase of securities or commodities with the expectation of making profits. In contrast, when a trader takes a short position, he or she sells securities or commodities with the intention of repurchasing them later at a lower price.read more), which has to be greater than the average return on the market.

#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 averageSimple Moving AverageSimple moving average refers to a type of moving average, and it is derived by calculating the average of prices or values observed over a specific number of days or periods.read more [SMA or MA] 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/

[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

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

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 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 correlatedNegatively CorrelatedA negative correlation is an effective relationship between two variables in which the values of the dependent and independent variables move in opposite directions. For example, when an independent variable increases, the dependent variable decreases, and vice versa.read more 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 bearishBearishBearish market refers to an opinion where the stock market is likely to go down or correct shortly. It is predicted in consideration of events that are happening or are bound to happen which would drag down the prices of the stocks in the market.read more, we will go short for Papa John’s and long for another.

Advantages

The strategy is easy to understand and implement.It helps reduce the general market riskMarket RiskMarket risk is the risk that an investor faces due to the decrease in the market value of a financial product that affects the whole market and is not limited to a particular economic commodity. It is often called systematic risk.read more to a greater extent.It is better than other arbitrage strategies.It has the least positive correlationPositive CorrelationPositive Correlation occurs when two variables display mirror movements, fluctuating in the same direction, and are positively related. In layman’s terms, if one variable increases by 10%, the other variable grows by 10% as well, and vice versa.read more with the market movements.Quick implementation and earning the profits are possible once we know the concept.

Disadvantages

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 the 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.

Conclusion

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 riskSystematic RiskSystematic Risk is defined as the risk that is inherent to the entire market or the whole market segment as it affects the economy as a whole and cannot be diversified away and thus is also known as an “undiversifiable risk” or “market risk” or even “volatility risk”.read more, not the unsystematic riskUnsystematic RiskUnsystematic risk refers to risk that is generated in a specific company or industry and may not be applicable to other industries or the economy as a whole. There are two types of unsystematic risk: business risk and financial risk.read more. Hence, even after using the strategies, what actually we are exposed to is Unsystematic risk. Thus, proper selection of stock is essential before trading.