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Market neutral strategy

I often come across strategies that say they are "market neutral".

There are lots of allusions about how you are protected on the long and short side, but I can't find anything about what this actually means.

How do you make money if a portfolio is market neutral? Is this similar to pairs trading?

3 responses

Pair trading is NOT market neutral. One would say it is dollar neutral. Please google it.

So if you are really have market neutral portfolio you can make money on an all sorts of premias/bonuses/dividends and so on, so I'm sure total returns should depend on time.

Market neutral means that the strategy will make money in any market conditions. The market could be going up, down or sideways and the strategies returns are not decided by the direction of the market. We measure market neutrality in terms of beta. You will see beta and then a numerical value in the back tester. A beta of 0 means that the strategy is totally independent of the market, but that is very hard to achieve in practice. Quantopian accepts a beta of between -0.3 and 0.3 for its portfolio, and I usually aim for -0.1 > beta > 0.1 in mine. A negative beta is generated when the strategy loses money when the market makes money.

Topics to look at from here include beta hedging and otehr risk management topics.

Steve,

One way to see the effect is to put together a basket of large cap stocks (50-100), and go long. At the same time, short SPY. Update periodically. You should see a relatively flat equity curve, with beta zero. You won't make money, but you won't lose it either, relative to SPY.

Grant