Neutral Options Strategies Every Trader Should Know

Staying neutral can be difficult, whether in lunchroom arguments at work, watching a battle between rival sports teams or trading stocks in a volatile market. But one of the advantages of markets is that even neutral positions can potentially be profitable when appropriately constructed. So investors expecting volatility could learn a few market-neutral options strategies, many of which can be deployed with options.

Choppy markets are among the most frustrating to trade in. When stocks can’t pick a direction, it puzzles bullish and bearish investors alike. That’s why institutions like hedge funds and large endowments often adopt market-neutral strategies, which can potentially be profitable regardless of the market trend direction.

Market-neutral strategies aren’t usually built to maximize profit but to potentially maximize the odds of profitability. To do this, market-neutral methods combine long and short positions, such as call and put options in the same trade. Market-neutral strategies hit their maximum payoff when the level of volatility can be predicted, not the direction of stock prices.

Here are eight neutral options strategies you can use whether volatility is expected to be high or low. Some trades do best during periods of high volatility, others when markets are flat. Market-neutral strategies potentially limit risk, but also take some profit opportunity off the top.

A covered call is a trading strategy where you sell (or write) a call option on a stock you already own. If the stock price increases above the call option’s strike, the buyer can execute the option and “call” in the stock owned by the option writer. In this scenario, the writer keeps the premium if the call is exercised or the stock plus the premium if the call expires worthless. Profit is limited, but so is the risk.

To use a short straddle, a trader would sell both a call and put option on the same underlying stock with identical at-the-money (ATM) strike prices and expiration dates. This trade is ideal when volatility is expected to be low, so the writer can collect option premiums without owning the underlying stock. Losses occur if the stock trades outside the strike price range plus the premium of the two options.

The long straddle is the opposite of the short straddle — profit is achieved when volatility is high, not low. In a long straddle, the trader would buy put and call options of similar strike price and expiration. If the stock price stays flat, the options expire worthless, and the trader loses  the premium. But if the stock is volatile, one of the two options will increase in value.

An iron condor is an advanced trading strategy involving four options to profit from low volatility — two calls and two puts. To execute this trade, you would buy an out-of-the-money (OTM) call, sell an ATM call, buy an OTM put and sell an ATM put. The two OTM options with higher and lower strike prices protect against a significant move in the underlying stock. Profit would see all four options expire worthless, allowing the trader to pocket the premium of the two ATM options.

An unbalanced iron condor has a similar construction to the traditional iron condor, but additional options are used to give the trade a bearish or bullish slant. For example, instead of buying and selling an equal number of calls and puts,  you might buy two OTM puts and sell two ATM puts versus one long call and one short call. The additional options give the iron condor a bullish slant, hence the name unbalanced iron condor.

If you’re expecting high volatility but are unsure of the direction of the price movement, a long strangle could be an ideal strategy. First, you buy a call option with an OTM strike price and then a put option with an opposite OTM strike price, both with the same expiration. For example, if the underlying stock is $10, you’d buy a $5 put and a $15 call with the same expiration date. If the stock price moves outside the $5 to $15 range, max profit is attained.

Opposite the long strangle is the short strangle, which is used when volatility is expected to be low and price movement flat. For example, you would sell the $5 put and $15 call options instead of buying opposite OTM call and put options. If the underlying price stays flat, the options expire worthless, and you pocket the premium. Losses can  be unlimited if the stock price rise significantly above $15.

The iron butterfly combines a long strangle and a short straddle in a complex trade designed to profit from limited volatility. The trade involves four options with three different strike prices. First, you buy an OTM call option and an OTM put option to protect against large moves upward or downward. Next, you sell a put and a call option at or near the current stock price. If the stock stays flat, the two OTM options expire worthless, and you can collect the premium on the two written options. Note that an iron butterfly should be exited when profitability is achieved to avoid assignment risk.

Volatility can be a good or bad thing, depending on an investor’s goals and mindset. But for large institutional traders, market-neutral strategies are crucial to limit risk and enhance profits regardless of price trends or market sentiment.  

Options traders can also benefit from market-neutral strategies by constructing positions that profit from volatility — or lack thereof — and don’t need stock prices to move in a specific direction. Remember that these complex strategies limit the upside should the underlying asset rise or fall significantly. Always calculate the max profit and loss of your options trades before putting any capital at risk.

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