Market-Neutral Trading Strategies
Last Updated on February 20, 2023
Fund managers use different strategies to maximize returns and minimize risks for their investors. One of the strategies they use to hedge risk is market-neutral trading. This approach not only helps to reduce beta but also reduces systemic risks. But what are market-neutral trading strategies?
A market-neutral strategy is a type of investment approach that enables an investor to benefit from both rising and falling stock prices. This is achieved by taking long positions in one stock and short positions in another stock. The strategy is designed to reduce exposure to specific market risks and can be applied in one or more markets.
In this post, we take a look at market-neutral trading strategies, and we finish the article with a backtest.
What is a market-neutral trading strategy?
A market-neutral strategy is a type of investment approach that enables an investor to benefit from both rising and falling stock prices. This is often achieved by taking long positions in one stock and short positions in another stock. The strategy is designed to reduce exposure to specific market risks and can be applied in one or more markets.
The strategy balances the returns from well-selected stocks with the reduction in returns from broader market fluctuations, as the returns generated from this strategy are not affected by market swings and are not dependent on the actual price movements of the securities involved. This is why one of the main factors to consider when using a market-neutral strategy is identifying the type of market risk that needs to be reduced.
What are market-neutral strategies examples?
Hedge funds often use market-neutral strategies to exploit any momentum in the market while being protected from systemic risks. Holding a market-neutral position allows them to focus on absolute returns rather than relative returns.
An example of their market-neutral strategies may be to divide their budged capital into two and put half in a long position on one stock and the other half in a short position on a related stock, which could be a stock in the same industry or market sector. Holding 50% long and 50% short positions in related stocks or in the broader market affords them to balance out returns and reduce risks.
This way, if the market moves up, the losses from the short positions are offset by the profit made in the long investments, and if the market declines, the profits from the short position offset the losses from the long position.
How do market-neutral strategies make money?
Market-neutral strategies aim to profit from price movements in one or more markets while minimizing exposure to market risk. This is achieved by taking both long and short positions in different stocks. While this reduces returns from broader market trends, it enhances returns from smart stock choices.
The goal of market-neutral strategies is to generate returns that are independent of market swings and achieve a zero beta against its relevant market index. The approach makes money by exploiting pricing discrepancies between different securities, as their prices converge.
For example, a market-neutral strategy might take a long position in an undervalued stock and a short position in an overvalued stock. So, it profits from price convergence — when the undervalued stock rises and the overvalued stock declines. By taking both long and short positions, market-neutral strategies aim to reduce exposure to market risk and generate returns that are not tied to the overall movement of the broad market.
Understanding the basics of market-neutral trading
Market-neutral trading aims to benefit from both rising and falling stock prices. The strategy is a bit complex, but the idea is to minimize risk exposure, regardless of the direction of the general market. This is achieved by taking long positions in one stock and short positions in another stock.
By balancing long and short positions in different stocks, an investor is able to generate returns that are independent of market swings, thereby achieving a zero beta against the relevant market. Market-neutral traders often employ a variety of tools and strategies to achieve their goals.
For example, they might use long-short equity strategies to take advantage of undervalued and overvalued stocks, or they might use merger arbitrage to profit from the price differential between a target company’s stock price and the acquiring company’s stock price.
Market-neutral trading is often compared to long-short equity strategies, but they are not the same. The former focuses on making concentrated bets based on pricing discrepancies, while the latter aims to get long and short stock exposures across industries.
Advantages and disadvantages of market-neutral strategies
Market-neutral strategies come with some advantages and disadvantages.
Some of the advantages of market-neutral strategies include:
- Reduced market risk: Market-neutral strategies seek to reduce market risk by balancing long and short positions in different stocks. This helps to minimize the impact of market fluctuations and produce returns that are separate from market trends.
- Possibility of positive returns: By taking both long and short positions, market-neutral strategies offer the possibility of generating positive returns even in volatile or declining markets.
- Versatility: Market-neutral strategies can be applied to various markets and investment instruments such as stocks, bonds, and derivatives.
These are some of the disadvantages of market-neutral strategies:
- The strategies can be difficult for novice investors to grasp and put into practice.
- They offer limited returns compared to other investment strategies that take on more market risk.
- They often require a substantial investment, including financing costs for short positions, trading costs, and expenses for obtaining market data for analysis.
- They may require precise market timing to generate returns
The different types of market-neutral strategies
While there are many different ways of implementing a market-neutral strategy, such as merger arbitrage, shorting sectors, long-short equity, pair trading, and so on, the two popular market-neutral strategies are fundamental and statistical arbitrage.
In fundamental arbitrage, an investor uses a thorough analysis of a company’s financial health, market conditions, and competitors to make predictions about stocks that could converge in the future and then trade those stocks.
This strategy uses quantitative models and algorithms to analyze historical data, find price discrepancies, and make trades based on the data. The idea is to spot and trade stocks that are likely to revert to their price means. The major difference from fundamental arbitrage is that this method uses technical analysis and quantitative models, while fundamental arbitrage uses fundamental analysis.
How to implement market-neutral strategies in your portfolio
To implement market-neutral strategies in your portfolio, you understand the strategies and follow the normal steps of creating a portfolio strategy. Here are some key steps:
- Determine your risk tolerance: While market-neutral strategies can reduce market risk, they still involve taking on some level of investment risk. So, be sure that the risks are what you can stomach.
- Select your stock or security universe: You must have a method of picking the right stocks. Your focus should be on related stocks with price discrepancies that can converge in the future. Select your universe of long and short stocks. You may even include other instruments.
- Create a balanced portfolio: To reduce market risk, you have to create a balanced portfolio of long and short positions in different stocks or investment instruments, such as bonds and derivatives. You can use tools such as merger arbitrage or shorting sectors to execute your market-neutral strategy.
Risk management in market-neutral trading
Although the market-neutral strategy inherently reduces market risk, the use of certain risk management techniques is necessary. Here are some ways to manage risk in market-neutral trading:
- Diversification: Diversifying your portfolio across multiple markets and geographies can help further reduce risk, especially the risk of divergence in the prices of the stocks invested. It also improves your portfolio returns.
- Position sizing: It is important to manage position sizing carefully and not to trade with so much leverage.
- Regular portfolio rebalancing: It may be necessary to regularly rebalance your portfolio so as to keep maintaining your desired level of market exposure and risk tolerance.
- Monitoring your trades: You may need to monitor your trades closely to know when the long and short stocks achieve optimal convergence for you to close out with the best possible profit.
Factors that impact market-neutral strategies
Market-neutral strategies can be influenced by various factors, including liquidity, volatility, and regulatory changes.
Liquidity levels in the market can affect the efficiency and effectiveness of market-neutral positions. For example, if the portfolio of long and short positions has achieved optimal convergence and the trader wants to close out to lock in the profits, they may not be able to do so if liquidity is low. The widened spreads that accompany low liquidity can wipe out the profits.
Volatility in the market presents opportunities for pricing discrepancies but can also result in losses if trades are not executed carefully. Extreme volatility can lead to further price divergence between the long and short positions, instead of the convergence required to gain profits. This can lead to losses.
Additionally, changes in regulations can also impact market-neutral strategies. So, traders need to stay informed of any new regulatory developments to adjust their strategies as necessary.
The role of quantitative analysis in market-neutral trading
Quantitative analysis plays a critical role in market-neutral trading by providing traders with a data-driven approach to identifying pricing discrepancies and making investment decisions. This is performed with algorithms and statistical models to analyze large amounts of historical data and identify patterns and relationships in the market.
This information is then used to make predictions about future market behavior and inform investment decisions. By relying on a data-driven approach, market-neutral traders can reduce the impact of emotional biases and increase the consistency and accuracy of their trades. As such, quantitative analysis is a key tool for market-neutral traders seeking to generate positive returns and manage risk in their portfolios.
Choosing the right market-neutral strategy for your investment goals
To choose the right market-neutral strategy for your investment goals, you need to consider different factors. First, you must understand your level of risk tolerance. Also, you have to evaluate your financial goals, time horizon, and resources to achieve your goals.
Next, you must study the financial markets and investment tools, including stocks, bonds, and derivatives, to know the instruments to use for your strategy. You should also consider the resources available to implement and manage the strategy, including access to market data, analysis, and technology.
If everything is fine, you formulate your strategy (which could be statistical arbitrage, merger arbitrage, pair trading, or any other) and backtest it. It may be important to backtest as many strategies as you can and then chose the best option.
The future of market-neutral trading and its impact on the financial industry
Market-neutral trading is an evolving strategy. It can only become more popular in the future. With the increasing use of technology and data analysis in finance, market-neutral traders are likely to have access to more information and tools to help them execute their trades.
Most traders may prefer to focus on using statistical models and growth factors rather than fundamental arbitrage, as technology makes it easier to gain access to huge data and analyze them. Also, as investors become more aware of the benefits of reducing market risk, market-neutral strategies are expected to become more widely adopted.
However, regulatory changes and increased competition in the market could also impact the future of market-neutral trading. The impact of market-neutral trading on the financial industry will likely depend on how the strategy evolves and how investors respond to it.
What is a market-neutral alpha strategy?
Market-neutral alpha strategy is an investment method designed to provide significant alpha but little or no beta. Here, beta refers to the correlation of an investment with the usual swings in a broad stock market index such as the S&P 500, while alpha refers to the excess return beyond the market return earned through active trading.
A market-neutral strategy aims to deliver alpha by spotting and exploiting pricing inefficiencies in individual securities, rather than relying on market movements to drive returns. It achieves this by simultaneously taking long and short positions in the relevant securities.
Is market-neutral the same as long/short?
Market-neutral strategies are often compared to long/short equity funds, but they differ in that long/short funds strive to alter their long and short stock exposures across industries to capitalize on undervalued and overvalued opportunities.
In contrast, market-neutral strategies focus on making targeted investments based on pricing discrepancies, with the ultimate goal of achieving a zero beta against its relevant market index. This helps to hedge out systematic risk. Market-neutral funds use both long and short positions, but their objective is distinct from regular long/short funds.
Market neutral trading strategy backtest – does it work?
A backtest with trading rules and settings is coming shortly.