Trading Strategies for Neutral Markets
In earlier posts, we covered directional trading strategies that consist of option vertical spreads. A vertical spread can be a bullish (long call spread) or bearish trade (long put spread), but our trading toolbox still lacks strategies for trading neutral markets. A neutral market is the opposite of a trending market, where indexes are either moving up or down. In a neutral market, indexes are usually range bound, treading sideways, and not making significant moves up or down.
To trade neutral markets, there are three types of basic option strategies one can employ. Once you are able to understand the three basics strategies, you will be able to trade more advanced option strategies for neutral markets, like diagonals or double diagonals. The first neutral strategy is a butterfly spread, which is a mix of two vertical spreads that expire in the same month. The two vertical spreads share one common strike. The second strategy is a calendar spread, which is a mix of two options (same strike price) that expire in different months. The last of the three basic neutral strategies is the Condor, which is basically a modified version of the butterfly strategy. The idea behind all of the strategies described above is to take advantage of the option greek – theta.
As we discussed earlier, theta provides a measure of time decay or the change in an options value with each passing day. With a long butterfly or a long calendar spread, you position will be theta positive, meaning that with each passing day, your trade will make money. By placing this type of trade in a neutral or sideways market, the intent is to take advantage of theta as the market stagnates. This is not to say that you cannot place a butterfly or calendar spread with a directional bias.
In summary, the three basic strategies for neutral markets are as follows:
- Butterfly Spread
- Calendar Spread
- Condor Spread
In subsequent posts, we will cover each of these strategies in detail.
Happy Trading!!
