13. Market-Neutral Strategy

Published at 1650194013.707


Market neutral is a group of investment strategies undertaken by an investor who simultaneously opens long and short positions in order to minimize market risk on portfolio returns. It’s useful when investors want to remove market volatility from portfolio returns to focus on forecasting stock returns. This strategy has two main characteristics:

  • Can yield profits regardless of whether the market rises or falls;

  • Open opposite directions simultaneously with equal market risk.

In the stock market, investors often use beta from the Capital Asset Pricing Model (CAPM), as  a measure of systemic risk. In this context, a market-neutral portfolio is defined as a portfolio with a beta of 0.

Pairs trading is a simple and common form of market neutral. The purpose of a pair trading strategy is to look for stock pairs that have a highly correlated price history. When the price correlation of two stocks deviates from the long-term average, investors buy stocks that are underperforming while selling stocks that are outperforming. They expect that this deviation is temporary. When the price correlation of two stocks converges to the expected average, investors close positions to realize profits.

Statistical Arbitrage (StatArb) also a group of market-neutral strategies that evolved from the pair trading strategy. It uses mathematical and statistical models along with computer assistance to make the most of the trading opportunities. These opportunities come from abnormal changes in the relative price of one stock to another.

In terms of classification, the statistical arbitrage strategy group includes pair trading. Pair trading can be considered a statistical arbitrage strategy. However, statistical arbitrage is not exactly pair trading. With the help of computers, statistical arbitrage strategies can combine buying/selling two portfolios with hundreds of different stocks. At that time, investors will select potential stocks and rank them according to relative valuation criteria. Then they buy “relatively cheap” stocks while selling “relatively expensive” stocks.

Examples of Market Neutral Strategies

Suppose the investor has just analyzed and selected a portfolio of 5 stocks in VN30 as follows: FPT, HPG, TCB, VIC, VPB (referred to as “VN05”). Investors predict in the future, the VN05 portfolio will be better than the general market. As a benchmark, the general market is the VN30 index. They decide to invest 600 million VND according to the market-neutral strategy as follows:

  • Buy 500 million VND in VN05;

  • Deposit 100 million VND to open 5 short positions simultaneously (assume VN30F1M index is 1,000;  margin is 20%; and VN30F1M price changes entirely correlated with VN30 index score).

Assume the VN05 portfolio has better performance than the general market. If the market increases, VN05 increases more. And conversely, if the market falls, VN05 falls less. Excluding fees and taxes, assume 2 market scenarios with investment results as follows:



If the market rises, VN30 increases. The short position on VN30F1M incurs a loss. However, investors expect the VN05 portfolio to increase stronger than VN30 (12% vs 10%). The profit from the VN05 portfolio offset the entire loss from the short position. The final profit is 10 million VND.

Conversely, if the market falls, the VN05 portfolio incurs losses. However, the investors expect VN05 to fall less than the market (say -8% versus -10%). At the time, the profit from the short position offsets the entire loss from the VN05 portfolio. The final profit is also 10 million VND.

Strengths of the Market-Neutral Strategy

As in the example above, with the market-neutral strategy, investment results depend primarily on selecting the right stock portfolio with better potential than the market average. It’s not dependent on accurately forecasting short-term price movements. Using this strategy, investors only need to focus on researching, understanding, and choosing a good portfolio of stocks with solid fundamentals. The portfolio should have high-profit potential in the long term, not worrying about short-term market fluctuations. Short-term events appear very random, and difficult to predict properly. They can only be perceived when they have occurred, and there’s no time to act at such moment. In addition, it saves a lot of time and effort from monitoring the market and daily fluctuations.