What are Neutral Options Strategies? Meaning & Types

The stock market roars, quiets down and then falls silent. In this unpredictable environment, traders usually follow the trends, hoping to profit from rising or falling stocks. But what happens when a stock isn’t moving at all? Traders often experience these stagnant periods, sometimes lasting weeks or months.

Going long or short during these times doesn’t yield much and can result in losses. However, adopting a market-neutral approach can prove more profitable than trying to predict market movements.

How does this work? Through neutral options strategies. Traders use these methods when they anticipate minimal stock price changes or are unsure of the market’s direction. Let’s dive into the top neutral options strategies that can keep you ahead, regardless of the market’s behaviour.

What Is a Neutral Trend?

A neutral trend represents a phase in which neither upward (bullish) nor downward (bearish) momentum dominates the stock price or overall market movement. This typically results in a sideways or stable price action, reflecting an equilibrium between buyers and sellers. This state suggests that the market consolidates recent gains or losses, preparing for a potential future directional shift.

Several factors can contribute to a neutral trend, including:

The market attempts to balance and consolidate before making a significant move.
A lack of impactful macroeconomic updates or data announcements.
An evenly balanced sentiment among options traders, with no prevailing optimism or pessimism.

Options traders often employ various technical analysis tools to detect neutral trends. Popular choices include moving averages, Bollinger Bands, and oscillators such as the Relative Strength Index (RSI), which help identify periods when the market is experiencing minimal directional movement.

Advantages of Neutral Options Strategies

Here are some key benefits of neutral options strategies:

Benefit from Time Decay (Theta): Neutral strategies often capitalise on the natural decay of options’ value over time, known as theta decay. This aspect is particularly advantageous in flat market conditions, where out-of-the-money (OTM) options tend to lose value faster as expiration approaches.
Income Generation through Selling Options: Traders can generate income by selling options, especially in periods of low market volatility when options premiums are relatively lower. This approach allows traders to profit from selling options contracts.
Profits in Non-trending Markets: Unlike strategies that require significant directional moves, neutral options strategies can yield profits in stagnant or range-bound markets. This is an attractive option in volatile or uncertain market conditions.
Diverse Strategies for Various Conditions: There is a variety of neutral options strategies available, such as iron condors, butterflies, and calendar spreads. These can be tailored to fit different market scenarios and individual risk preferences.

Drawbacks of Neutral Options Strategies

Despite the benefits, neutral options strategies have the following drawbacks:

Capped Profit Potential: While these strategies can offer a steady income stream by selling options, they inherently limit the maximum possible profit to the premiums received at the trade’s outset.
Vulnerability to Market Surprises: Neutral options strategies are susceptible to sudden market movements caused by unexpected geopolitical or economic events. Such shifts can lead to substantial losses if the market moves strongly in one direction, offsetting the gains from one side of the strategy.
Complexity and Management Challenges: Some neutral strategies, including iron condors and calendar spreads, involve multiple positions or “legs.” These can be complex to set up and require a solid understanding of options trading and risk management to maintain and adjust effectively.

List of Neutral Options Strategies

1. Covered Call Strategy

This strategy involves holding a stock and selling a call option on the same stock. If the stock price remains below the call’s strike price at expiration, the call expires worthless, allowing the seller to retain the stock and the option premium. However, the shares may be called away if the stock price exceeds the strike price. The maximum profit is limited to the option premium plus any stock price appreciation up to the strike price. This strategy is typically used by neutral traders to moderately bullish on the underlying stock.

2. Collar Strategy (Covered Call Collar)

The collar strategy enhances a basic covered call approach by adding a protective put to guard against significant stock price declines. This strategy involves owning the stock, selling an out-of-the-money call, and buying an out-of-the-money put with the same expiration date. The protective put acts as a safety net, limiting potential losses, while the sold call generates income. This strategy is suitable for protecting existing stock positions while generating income.

3. Covered Put Strategy

In this approach, the trader holds a short position in a stock and sells a put option. The put option is generally out-of-the-money. This strategy is favoured by neutral to moderately bearish traders on the stock, aiming to earn through the premium collected from the sold puts.

4. Short Straddle Strategy

This involves simultaneously selling an at-the-money call and put option with the same strike price and expiration date. It is best utilised in scenarios where the trader anticipates low volatility and aims to profit from the premium collected from both options. The risk with this strategy is potentially unlimited if the stock price moves significantly in either direction.

5. Short Strangle

This strategy involves selling an out-of-the-money (OTM) call and an OTM put. It is particularly effective when traders anticipate that the stock will remain within a certain price range. This allows them to capitalise on a decrease in stock volatility and collect premiums from both options.

6. Short Gut

The short gut strategy entails selling an equal number of in-the-money (ITM) calls and put options on the same stock with the same expiration date. This approach is employed when the strike prices are equidistant from the stock’s current market price, aiming to profit from the premiums while the stock price remains stable.

7. Calendar Call Spread

This spread involves writing a near-term call option while simultaneously buying a longer-term call option at the same strike price. It’s designed to take advantage of time decay and is suitable for a neutral to slightly bullish view of the stock.

8. Calendar Put Spread

A strategy for those with a neutral to bearish outlook involves buying a put option with a longer expiration and selling a shorter-term put at the same strike price. This strategy aims to profit from the erosion of the short put’s time value.

9. Call Ratio Spread

This involves buying calls at a lower strike price (in-the-money) and selling more calls at a higher strike price (out-of-the-money). It is structured to benefit from a neutral to bullish sentiment on the stock, leveraging the balance between premium income and potential stock appreciation.

10. Put Ratio Spread

In this three-legged strategy, the trader buys put options that are in-the-money or at-the-money and sells a higher number of out-of-the-money puts. The version where more OTM puts are sold is known as a put ratio front spread while buying more OTM puts is referred to as a put ratio back spread. This strategy is tailored for a neutral market view, balancing risk and potential reward through strategic option placement.

11. Iron Condor Spread

This strategy utilises four different options across two calls and two puts, all with identical expiration dates. The structure is divided into:

Long Iron Condor:

Buy a far out-of-the-money (OTM) put
Sell an OTM put
Sell an OTM call
Buy a far OTM call

Short Iron Condor:

Buy an OTM put
Sell a far OTM put
Buy an OTM call
Sell a far OTM call

The strike prices for the bought and sold options are strategically placed at equidistant points. Optimal profit is achieved if the stock price at expiration lies between the strike prices of the sold options, with the maximum risk being the net difference in the strike prices minus the premium received.

12. Iron Albatross Spread

Often referred to as an expanded version of the Iron Condor, the Iron Albatross spread involves:

Buying far OTM call options
Selling an OTM call option
Buying far OTM put options
Selling an OTM put option

This configuration aims to maximise profits from the premiums received while the losses are capped at the difference between the strike prices of the traded options.

Leveraging Market Neutrality for Profit

In dynamic global markets that can shift unpredictably, neutral options strategies provide a strategic edge. They allow traders to benefit from market stability, hedge against potential volatility, and secure steady income even when the market is dormant. These strategies demand careful planning and risk assessment but offer substantial potential benefits.

By harnessing the power of market neutrality through strategies like the Iron Condor and Iron Albatross, traders can turn market indecision into a significant advantage. These approaches help mitigate risks and position traders to capitalise on market stability, making them invaluable tools in a well-rounded trading strategy.