Market Neutral Trading
It’s become a kind of cliché to say that someone “wrote the book” on something, but when we are talking about market neutral trading, I actually did write the book! Market Neutral Trading is my third in a series of books on trading the stock market. What follows has been adapted from chapter 1. I want to show you why market-neutral trading is such a powerful profit generator while at the same time lowering risk.
From the best paid hedge fund manager to the smallest retail investor, everyone who is in the market has the same two goals: to increase the returns and to lower the risk. Most professional investors will tell you that it is virtually impossible to attain both goals at the same time. Most approaches to the market, therefore, specialize in one or the other.
Consider the following comparisons:
- Buying large-cap stocks vs. buying small-cap stocks
- Investing in utilities vs. investing in solar energy stocks
- Investing in value stocks vs. investing in growth stocks
In each case the relative risk is lower on the left side of the comparison and higher on the right. At the same time, the potential return on investment has historically been higher on the right side than on the left. This contrast sets up a fundamental sacrifice that every investor must make: am I going to give up lowering my risk in exchange for potentially higher returns, or should I go after higher returns but take on more risk?
Here is some good news: with market neutral trading you don’t have to make this sacrifice. Let me explain. Market neutral trading aims at what is called “double alpha”. “Alpha” is a term used by fund managers to describe a measure of outperformance relative to some benchmark index. Risky investing strategies aim for scoring alpha during bull markets, but expect to underperform in bear market. Safe, risk-off investing strategies aim for producing alpha in more volatile markets but only expect to match the benchmark in strong bull markets. A market-neutral approach, on the other hand is positioned to outperform in all market types. Whether there is a raging bull market on or the market is falling off a cliff, a market-neutral portfolio, when configured properly, is positioned to win alpha.
Market-Neutral vs. Hedging the Market
Before I define more specifically what is meant by a market-neutral approach, let me first explain what it doesn’t mean. Market-neutral investing or trading is not a form of “hedging” the market. Hedging is used to minimize potential loss in one’s portfolio when market conditions turn unexpectedly bearish. A hedged portfolio can come in a variety of forms. One can hedge a set of longs, for example, by buying an inverse index ETF, selling calls against the shares, buying out of the money puts, shorting stocks from the same industry as the longs, and so on. In every case, one side of the hedged portfolio is expected to lose money.
The hedge is therefore a kind of two-edged sword: it reduces your overall profits if your longs continue to run higher, but it can also help to minimize your losses should your positions suffer a pullback. In other words, hedging is like paying an insurance premium: it is a pain to pay it each month but you are glad to have the coverage when disaster strikes.
Market neutral trading, on the other hand, operates from a very different mindset. If hedging is about paying a premium to buy down risk, market-neutral trading is about reducing risk without having to pay a premium. Hedging is motivated by the fear of substantial losses. Market neutral trading is motivated by the quest for outsized gains. Hedging is most commonly used during market downturns. Market neutral trading can profitably be done in all market conditions.
What Market Neutral Trading Is
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