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A portfolio is truly market-neutral if it exhibits zero correlation with the unwanted source of risk. [1] Market neutrality is an ideal, which is seldom possible in practice. [2] A portfolio that appears market-neutral may exhibit unexpected correlations as market conditions change. The risk of this occurring is called basis risk.
A pairs trade or pair trading is a market neutral trading strategy enabling traders to profit from virtually any market conditions: uptrend, downtrend, or sideways movement. This strategy is categorized as a statistical arbitrage and convergence trading strategy. [ 1 ]
As with most successful arbitrage strategies, convertible arbitrage has attracted a large number of market participants, creating intense competition and reducing the effectiveness of the strategy. For example, many convertible arbitrageurs suffered losses in early 2005 when the credit of General Motors was downgraded at the same time Kirk ...
Market neutral strategies can be seen as the limiting case of equity long/short, in which the long and short portfolios of the fund are balanced with great care so that a very high degree of hedging is achieved. Some advantages of market neutral strategies include being able to generate positive returns in a down market, and generating returns ...
In neutral or bear market scenarios, the advantages of market neutral long-short are prevailing. In bull markets, market neutral long-short strategies tend not to be able to generate better returns than other investment strategies. In comparison, it would be advantageous to invest into a 130–30 fund in a strong bull market.
Fixed-income arbitrage is a strategy that involves a substantial level of risk. The strategy itself provides relatively small returns that can be offset with huge losses given varying market conditions and poor judgement calls. Due to the risk-return nature of the strategy, it is not often used by common investors.
Market-neutral trading is a way to combine long positions with short ones. Rather than place your bets on upward or downward trends, this strategy takes advantage of volatility while mitigating risk.
Pairs trading or pair trading is a long-short, ideally market-neutral strategy enabling traders to profit from transient discrepancies in relative value of close substitutes. Unlike in the case of classic arbitrage, in case of pairs trading, the law of one price cannot guarantee convergence of prices.