Market Neutral Strategy: How Do You Know If A Market is Neutral?
Key Questions Answered
Investors often look for the ideal investment strategy that enables them to make a profit in both bull and bear markets. The ideal scenario for them is to minimize risks to be negligible while still being able to make profit off an underlying asset’s price movement. It’s difficult to optimize for these scenarios, but risk mitigation techniques can come in handy.
What is Market Neutral?
The concept of market neutrality refers to when investors can specifically design strategies to offset the risk of volatility in any financial market depending on the asset chosen for their portfolio.
What is a Market Neutral Strategy?
This type of investment strategy allows traders to design or pick strategies in a manner to make gains from both increasing and decreasing prices, in an attempt to avoid a specific form of market risk.
The strategy is often popular amongst those with lower risk appetites and investment managers who have the responsibility to not use high-risk strategies with their client’s funds.
Market neutral pair trading (Source: tradingstrategyguide.com)
Market Neutral Strategies in Crypto
In the cryptocurrency markets, market neutral strategies are extremely relevant due to the highly volatile markets. These strategies can be used to hedge other risky positions in an investor’s cryptocurrency portfolio and offset volatility risk.
Different Market Neutral Strategies
Basis Trading usually includes a long position in the underlying crypto-asset and a short position in its derivative. ‘Cash and carry’ is referred to when the basis trading strategy utilizes the price differential of two markets.
These trades generally consist of open positions in the spot market as well as a futures contract.
Futures contracts are often priced higher or lower than the underlying spot market price, so the basis can be both positive or negative.
Fundamental market-neutral funds use fundamental analysis, rather than quantitative algorithms, to make trades based on predicted asset price convergences.
Statistical arbitrage market-neutral funds use algorithms and quantitative methods to reveal price discrepancies between two or more crypto-assets. Based upon these quantitative findings, investment managers speculate on the prices of selected crypto assets to revert by opening long and short positions simultaneously. To build a position, traders choose crypto assets that display a solid positive price relationship using statistical methods such as correlation and co-integration.
Pros and Cons of Using Market Neutral Strategies
Benefits of Using Market Neutral Strategies
Market-neutral strategies benefit traders through diversification, a negation of volatility, and risk mitigation.
- Diversification – Traders incorporate different strategies to diversify their returns over time and manage their risk efficiently. Long-term returns are not linked to the performance of a few strategies.
- Volatility dampening – The market-neutral strategies bring a lower volatility outcome in comparison to conventional strategies. Market-neutral returns are usually individualistic of the broader market. However, a change in the market-level volatility may not have an effect on the strategy.
- Risk mitigation – Another advantage is that market-neutral strategies help traders to mitigate critical losses during a market sell-off. Generally, these strategies have a beta-neutral exposure towards the market so sharp movements should not significantly impact the performance.
A great benefit of market-neutral strategies is their emphasis on building portfolios to mitigate market risk. In volatile markets, past results have shown us that market-neutral strategies are likely to outdo other strategies.
Disadvantages of Using Market Neutral Strategies
Market neutral strategies provide unique benefits such as diversification and portfolio volatility reduction. However, there are also risks and disadvantages which managers need to consider.
- Execution risk – During volatile market periods, executing two-legged spreads can be a challenge. Price movements can be sharp and fast-changing, which may lead to slippages.
- Correlation/Co-integration failure – It is of utter importance to be updated with the changes in correlation the fundamental factors involved may influence individual price movements of crypto assets. When this happens, a trade can rapidly go south as assets move in different ways than anticipated. Historic behaviors don’t always repeat.
- Price Filling – Gaining in pairs-trade or arbitrage frequently depends on very small margins, so there is a major risk that orders will not be filled at the desired price when opening or closing positions in a pairs-trade. In particular, pair trading takes place in markets where liquidity is low, which generally takes place on small-cap altcoins.
Market-neutral strategies may be better at times compared to a traditional long-only portfolio. A well-designed market-neutral strategy can provide additional returns regardless of the swings in the broader crypto markets. Therefore, it should help guard traders against periods of unnerving volatility.
While market-neutral trading can alleviate risk and allow traders to profit in various market conditions, it requires active management as traders must be updated with market developments to mitigate risk.