Neutral market strategy

The neutral market strategy or market-neutral strategies are techniques used by investors that consist of taking positions ( long and / or short ) whose result does not depend on the profitability of the market or the assets in which it operates.

Neutral market strategies are those whose outcome does not depend on one or more assets rising or falling. That is, they are independent of the individual price movement. As the name implies, they are neutral to the market. When we talk about the neutral term, we refer to something similar to the term “indifference.”

Theoretically, these strategies can achieve positive returns regardless of what the market does, since they try to eliminate systematic risk , while maintaining long and  short positions at the same time.

So, suppose there are no transaction costs. That is, suppose there are no commissions of any kind when we operate in the stock market. If we buy shares of a company (long position) and at the same time we sell shares of that same company (short position), our profit will be zero. For example, we have a share of company X. The price of company X goes up from 10 to 15 dollars. Therefore, the long position will have a profit of 5 dollars and the position cuts a loss of 5 dollars. Whereupon we will not have won or lost.

Of course, these types of strategies seek to make a profit. It makes no sense to apply these types of techniques if we are not going to make a profit. In addition, in reality, applying the previous case we would obtain losses. Why? Because if we include the commission to be paid for each operation, the result is negative.

How do you get benefit by applying these types of strategies?

In the first place, it is necessary to explain how profit is obtained with market-neutral strategies. The fundamental idea of ​​these types of strategies is based on the fact that markets are not efficient. Which means that the same asset or closely related assets may have different prices.

A very common example in these cases would be to compare the futures market of a stock and the spot market. If the markets were perfect and efficient, there would be no differences. However, the truth is that it exists. Let’s see the following graphic:

The chart above shows how the same asset has different prices in different markets. At the beginning, futures contracts have a lower price. Subsequently they have a higher price. We do not know if the company’s price will move up or down. But what is certain is that sooner or later futures must match their price to the cash market. It is from these differences where we can extract a benefit.

Types of market neutral strategies

In the previous example we have revealed a type of market-neutral strategy. Of course, there are many types of strategies within this classification. In a generic way we can distinguish three types. Which, in turn, are composed of some more specific.

  • Relative value strategies:They are formed by the set of techniques whose objective is to exploit price inefficiencies. Thus, by means of two or more operations in different instruments and in the opposite direction they are intended to reduce the risk. So that the risk of long positions is absorbed by short positions. And vice versa, the risk of short positions is canceled by long positions.

This technique is the most famous and proven in the stock market investment. Among the relative value strategies are:

  1. Fixed IncomeArbitration
  2. Arbitration equity
  3. Statistical arbitration
  4. ConvertibleArbitration
  5. Arbitration of mortgage-backed securities (MBS)
  • Strategies driven by events: Theyestablish the set of techniques based on specific events. These specific events can lead to investment opportunities. For example, companies in suspension of payments, mergers, removals or acquisitions.

This technique involves more risk than the previous one and we can find several subtypes:

  1. Titles or values ​​in danger
  2. Merger Arbitration
  • Opportunisticstrategies : Opportunistic strategies try to generate profit through a detailed analysis of the economy and its forecasts. They make predictions about interest rates, exchange rates, monetary policies, asset quotes, etc.

It is the technique with the highest risk of the three indicated. It can be subdivided into:

  1. Macroeconomic
  2. Emerging markets
  3. Coverage in equities
  4. Long / short equity strategies

Risk of neutral market strategies

These types of strategies, are considered in themselves, as little risky. However, we can establish a relationship between type of strategy and risk .

In any case, it is vitally important to understand that risk is something very difficult to measure. In some cases the only thing we can get are approximations. That is, they are estimates. A very simple example is the volatility of a stock. That the volatility of an action has not exceeded 10% for 20 years, does not mean that, at a certain moment, it can exceed that level. Whereupon, the previous image is merely indicative.


by Abdullah Sam
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