The term “market neutral investing” in a generic description of any strategy that involves taking positions on both sides of a security, or within a given market segment, for the purpose of limiting downside risk . In other words, they hedge themselves against moves in either direction.
The purest form of market neutral investing is executing a buy order and going short on different stocks in the same niche, in equal amounts, and at the same time. The effect is that when the niche as a whole moves in one direction, money is made by that position, while the other position becomes a “hold,” or even a mitigating trade if cash is required.
How It Works
The thinking is that if the niche isn’t moving, money can be made by predicting the fundamental winners and losers within it. Even if the investor is wrong about the specific stock, a general move in the market or the niche, in effect, covers their loss with a winning trade on the other side of the movement.
There are a variety of tools, alternatives and sub-strategies than can be applied to a general market neutral approach. This is usually – and best – done by sophisticated fund managers who understand how to manipulate holdings and trades to hedge themselves against loss while opening themselves to some upside.
When a stock they happen to hold moves in the right direction, they make money. When the entire niche tanks, they are covered because they are market neutral by virtue of having shorted other stocks within that niche, and in an amount that precisely covers the long position.
When a given stock goes down, there is a corresponding long position matching that position to cover the loss. Hedge funds are built upon this principle.
Market Neutral Investing for Individuals
One way individual investors can use this principle is to use options contracts, which are, in effect, futures.
For example, let’s say you buy 100 shares of a stock at$20. You can do several things with this. First, you can ‘write” (sell) a covered call option contract at a $20 strike price and get paid from $1 to $3, depending on the outlook of the stock. If the option expires in the money (above $20), you’ll have to sell your shares at $20, but you get to keep the option premium, meaning you’ve made $41 to $3 per share. If the stock doesn’t go above $20 and the contract expires, nobody will execute the call and you still get to keep the money.
In effect, the stock would have to go down to $19 or to $17 (depending on the premium received) for you to experience a loss of any kind. This isn’t a pure market neutral strategy since there is still downside risk, but that risk is mitigated by the amount of options proceeds.
Another way to remain market neutral is, rather than selling calls, to buy puts or calls on the other side of your long or short positions.
For example, if you’re long 500 shares of XZZ, you can cover the downside risk by buying 5 puts of XYZ at or near a strike price near your basis cost. If the stock goes up enough to fund the cost of the puts, you’re making money. If the stock goes down at all, the premium value of the put covers the loss you have in the stock itself.
It’s a complicated strategy, even at this simple level, and it gets much more complicated when various tools are combined.
