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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 ]
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 ...
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.
As a result, under normal market conditions, the arbitrageur expects the combined position to be insensitive to small fluctuations in the price of the underlying stock. However, maintaining a market-neutral position may require rebalancing transactions, a process called dynamic delta hedging. This rebalancing adds to the return of convertible ...
The trading strategy is developed by the following methods: Automated trading; by programming or by visual development. Trading Plan Creation; by creating a detailed and defined set of rules that guide the trader into and through the trading process with entry and exit techniques clearly outlined and risk, reward parameters established from the outset.
Options market makers, or others, may form a delta neutral portfolio using related options instead of the underlying.The portfolio's delta (assuming the same underlier) is then the sum of all the individual options' deltas.
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.