Understanding Market Neutral Positions

Volatility can be a tough pill to swallow, especially when it can have such a large daily impact on your personal savings portfolio. However managing volatility as a personal investor can sometimes be overwhelming, in that there are so many confusing strategies available to choose from.

Depending on our ability to manage risk, and our individual level of sophistication as an investor, we need to be careful in choosing a risk management strategy. While diversification is always a must for a personal portfolio, taking additional measures to secure a portfolio against fluctuations can pay off great dividends in the future. Over the next few articles, I’m going to discuss a few simple strategies to hedge your portfolio against short term volatility through what is called a Market Neutral position.

A market neutral position involves investing in the short-term performance of a single security, and then investing against the short-term performance of another similar opportunity. In a perfectly efficient market, this sort of position would return a net yield of 0%, because the gains and losses in the two positions would cancel each other out. However, because no two positions are ever going to move in perfect unison, we are able to take advantage of discrepancies to create a limited return.

In general, the most basic way for an investor to take on a market neutral position is by purchasing equities in a single company, and then short selling the stock of a very close competitor. The rationality is that both of these companies compete in the same industry, operate under the same currency, and are therefore subject to all the same macro-economic risks.

The result is that you will be investing specifically in the performance of that individual company, because all macroeconomic changes will impact both companies equally. So if the Euro-crisis causes the industry to fall, both companies will fall equally, and your short position will make up for the loss. But if one company reports a larger increase in earnings than the competitor, the net increase in the price of the shares will be greater on the long side than the short, thus resulting in a profit for the neutral position.

While a market neutral equity position does create a nice hedge against macroeconomic risk, it does not protect an investor from any surprise earnings from either company. For example, if the short company suddenly has a very favorable period, you’ll lose money on the short position. Worse yet, if the reason for the short company’s sudden increase in value is because they have stolen market share from your long company, you might find your entire portfolio dropping out from underneath you.

Thus is the catch 22 of a market neutral position. While we are able to hedge out macro-risks, we need to be sure that we’re taking a long position that we are fairly certain will outperform the short position. Essentially, we want to be sure that the macro-risks that we will be negating will outweigh the company related risks that we will be taking on.