Predicting a market’s direction over a given time horizon is incredibly difficult. The best traders in the world are right just over 50 percent of the time, and you can imagine what it takes to get those kinds of results.
This is why many traders don’t even try to predict the direction of the market, utilizing instead what’s known as a market-neutral strategy. Here’s a look at what a market-neutral strategy is and some tools that market-neutral traders often use.
The basic idea behind a market-neutral strategy is to eliminate as much broad-market risk from a trade as possible. Market-neutral strategies typically involve hedging or buying one security for the sole purpose of offsetting, or partially offsetting, gains or losses generated by another. Many hedge funds and professional traders apply market-neutral principles to their portfolios specifically for this downside protection.
There are dozens of strategies for investors to use to try to be market neutral. Here are a few of the more popular ways it’s accomplished.
Futures are the holy grail for most market-neutral traders, as they literally offer a way to trade a market’s future direction.
There are futures products for every major market, including currencies and commodities, but the most popular futures contracts are broad equity index futures, specifically the E-mini S&P 500 futures. This tool gives traders the ability to go long or short the entire index nearly 24 hours a day, the idea being that the broad market exposure can serve as a hedge on nearly any trade.
Lightspeed offers active traders the ability to trade futures on specific futures trading platforms, Eze EMS (formerly RealTick) and CQG. Eze EMS (formerly RealTick) has two options based upon the needs of any trader, Eze EMS (formerly RealTick) Pro, and Eze EMS (formerly RealTick) Express. The main difference being that with Eze EMS (formerly RealTick) Express active traders receive four level II screens and the ability to view only 100 symbols at a time. The Eze EMS (formerly RealTick) Express version does not contain the advanced time and sales window or the alarms/alerts on the platform. Choosing a platform is entirely based upon a Trader’s strategy and preference. CQG is built on cloud infrastructure with the ability to trade from your desktop, tablet or mobile device. This platform delivers advanced futures market data, order management, and more.
For those who don’t have access to futures quotes, ETFs can also act as a good trading tool to be market neutral. Large, broad-based ETFs, like the SPDR S&P 500 ETF (SPY) have the same exposure benefits (albeit with a little less liquidity) as S&P futures.
There’s also an entire world of leveraged and inverse ETFs specifically designed for short-term trading. Many traders use these tools as hedges against a day or swing trade in a corresponding market. For example, a long crude oil trade could be hedged by going long an inverse oil ETF or shorting a leveraged oil ETF.
However, these instruments are structurally complicated. You shouldn’t trade a leveraged or inverse ETF without fully understanding how they work and what happens to them over time.
The flexibility offered by options make this another common way to trade market neutral. Because options can provide increased leverage, guaranteed income, and a set expiration date, many traders use them to provide insurance for themselves.
There are entire books describing options hedging strategies, and they can range from the simplest long call option (which could provide a hedge on a short position) or a short put butterfly, which involves buying two puts at a middle strike price, and selling one put against each at lower and upper strikes with the same expiration date.
Are you looking to trade futures or options? Lightspeed offers the lowest options commissions and has professional trading platforms based upon your needs and strategy. If you’re not sure which one you prefer, you have the opportunity to take the platform for a test drive with a demo version of the software. To begin trading stocks online with Lightspeed, open an account today.
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