A portfolio constructed so that net exposure to the overall market is close to zero, leaving return dependent on relative performance within the book.
Neutrality can be defined on dollars, on beta, or on a full factor model that also neutralises sector, size and style exposures. Each definition leaves different residual risks, and a dollar-neutral book can be far from beta-neutral.
Because the market component is removed, gross returns are small per unit of position, and leverage is typically applied to reach a target return. That leverage is the strategy's real risk: modest adverse moves in a crowded book become large losses once multiplied.
Neutral does not mean safe. The 2007 quant event and various subsequent short squeezes showed that neutral books can lose sharply when many participants reduce risk simultaneously. See factor-crowding and short-squeeze.
Original diagrams for the ideas on this page. Illustrative, not real market data.
Bollinger bands: squeeze and expansion. The middle line is a 20-day average and the outer bands sit a set number of standard deviations away, so they measure how far price has recently been straying. When moves are small the bands pinch together; when moves grow they spread apart.Margin and leverage. A $5,000 deposit can control a $100,000 position, which is 20:1 leverage. Because the loss is measured on the full $100,000, a 2.5% move against you halves the deposit and brings a margin call, and a 5% move uses all of it.
Educational only, not advice. Spotted an error? Post in Site Feedback.