Market-Neutral Investing

Where will the stock market be in 20 years? Higher, lower, or about the same?

How about in 5 years?

What about 1 month from now?

If I polled retail investors I'd bet that a great majority would say that the market will be higher in 20 years. For the 5 year timeframe I'd guess that most would say higher, but the percentage would drop. For one month, the number of people saying higher might drop to close to 50%.

When we invest with a market-neutral strategy we're not saying that the market is not going to move at all. We're simply saying we have no idea what DIRECTION the market will move.

So how do we do this? And more importantly, how can we make money?

I start by looking for diversified, liquid indexes that should track the overall market. My favorites are the SPX (S&P 500 index), NDX (Nasdaq 100 index) and the RUT (Russell 2000 index). These are all optionable and frequently traded.

Without getting too technical, there are two basic option strategies we employ to create our market-neutral portfolio. One is a credit spread and the other is a calendar spread. These are both risk-defined strategies, so we can know what our max gain and loss is from day one. We put these trades on every month in a consistent fashion. With good risk-management, we can get an edge on the market.

What these option spreads allow us to do is to define a range within which we can profit. The benefit is that every day that goes by with the index in our range, we make money. I don't know of any other investment where you can get paid for the market doing nothing!

So what's the catch, Tommy? It can't be that easy!

You're right. Remember, the index needs to stay in our range for us to make money. But what if the market really moves in one direction or the other? That's where the risk-management plan come into effect. Just because we know what our max loss is doesn't mean we want to get there!!!

The beauty of using these liquid options is the ability to make adjustments when necessary. It's like playing roulette, but being able to change your bet right up until the ball stops moving. When the market gets to one of our pre-determined points, we simply adjust our range out farther, or take the trade off for a smaller profit.

We also have to know that we won't win every time. This is the stock market we're talking about. Don't let the need to be right get in the way of making good profits.

Given the market we're in, I think this type of neutral strategy is a great way to generate profits and control risk. I like being able to make money whether the market goes up, down or stays the same.

So next time someone asks you "Where do you think the market is heading?" you can say "I don't have any idea, but I can still make money!"

Tommy Sikes