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The Best Neutral Option Strategy

By:Dr. Jim Schultz

Playing the market neutral is an option new traders don't always think of

  • Option strategies with a neutral bias can be just as effective as strategies with a long or short bias.

  • Generally speaking, newer traders with smaller accounts will opt for more defined-risk strategies, while more experienced traders with more capital tend to prefer undefined-risk strategies.

  • Two of the most common option strategies for a neutral bias are the iron condor and the short strangle.

When people think of the stock market, they always think that you make money if you’re on the right side of the directional move.

If you buy something and the price goes up, you make money. If you short something, and the price goes up, you lose money. Pretty simple and straightforward. But there is a third option that many newer traders don’t quite realize is available to them: playing the market neutral.

It is possible to play the market with no directional bias and profit from the stock not going too far in either direction. When you do this, one of the first decisions you’ll have to make is whether you want to use a defined-risk strategy or an undefined-risk strategy.

Defined risk or undefined risk?

Generally speaking, newer traders and/or traders with smaller accounts ($25,000 or less) gravitate toward defined-risk strategies for their positions. More experienced traders tend to use more undefined-risk strategies. This makes sense because while undefined-risk strategies might ultimately be more effective and produce better results, they do require more capital to hold on a pe- position basis. Not to mention, given the fact that undefined-risk strategies have no built-in safety net, they require a higher level of skill to manage and adjust appropriately.

Still, with either risk category, the important thing is to make sure that your position size is small enough to let the probabilities play out over time. This means keeping your defined-risk strategies to 1% to 3% of your net liquidating value, and your undefined-risk strategies to 3% to 7% of your net liquidating value. 

Iron condors or short strangles?

Two of the most common, neutral-option strategies are the iron condor and the short strangle.

The iron condor is a defined-risk strategy, while the short strangle is an undefined-risk strategy. With an iron condor, we typically like to collect at least 33% of the width of the spread. This means that with a $5 wide spread, you would want to collect at least a $1.67 credit, and with a $10 wide spread, you would want to collect at least a $3.33 credit, and so on.

With a short strangle, a great starting point is the 16 delta strike on both sides of the market—so a 16 delta put and a 16 delta call. From there, you can bring your strikes in, if you want to collect more credit at a lower probability, or you can move your strikes out if you’re willing to give up some credit in exchange for a higher probability. Furthermore, you can even asymmetrically adjust one side relative to the other, to introduce more of a directional bias in the position.

Jim Schultz, a quantitative expert and finance Ph.D., has been trading the markets for nearly two decades. He hosts From Theory to Practice, Monday-Friday on tastylive, where he explains theoretical trading concepts and provides a practical application of those concepts to a trading portfolio. @jschultzf3

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