Pick up the business section of any newspaper, or click through the stories on any major financial website, and nearly all of the coverage you'll read can be summed up as either bullish or bearish. That's because, for most investors, a simple up-or-down proposition is the most they can manage, but options allow us to express more nuanced views.
The epitome of a position that can only be expressed with options is a market-neutral spread like a butterfly, straddle, or iron condor - spreads that profit from the passage of time or from changes in volatility rather than from changes in the price of the underlying asset. Here are two reasons I think that market-neutral trading is a tool that should be in every investor's kit:
1. Picking a direction is difficult. Many traders like to use complicated technical analysis to divine likely direction from chart patterns. I'll concede that technical analysis can be valuable, but only when it is done in an objective, verifiable, historically-testable fashion. Skim through David Aronson's Evidence-Based Technical Analysis to get a sense of what I mean. If your chartology isn't based on something objective and repeatable - like any good scientific experiment - you're just begging to be influenced by a bunch of cognitive biases and subjective factors. Whether or not you watch charts, it's a good idea to have the ability to profit from directionless markets when there is no clear price trend or directional setup.
2. Capture other sources of edge. Every investor with an IRA or a Scottrade account is chasing the same small universe of stocks. Why follow that crowd when you could also look for profits based on other factors, like the tendency of stocks to mean revert over short time frames, or for options to be priced in excess of future realized volatility (i.e. the volatility risk premium)? Diversifying your sources of potential profits means you will be able to survive situations in which one method stops working: if all of your carefully-picked stocks stop trending higher, market-neutral positions can keep your profit/loss curve steady until those buy-and-hold positions recover.
Market-neutral spreads like straddles or condors aren't nearly as advanced or complicated as you might think: if you've ever bought a put or a call option, notice that buying a put and a call at the same time means you've put on a straddle position. Trading volatility instead of price does take a shift in the way you think about markets, but once you make that change, you'll never approach investing the same way. Trading only with the up/down, yes/no language of buyers and sellers is like trying to speak English without any adjectives.
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Jared can be followed on Twitter at twitter.com/CondorOptions
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