Editor's Note: Options are not suitable for all investors. Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Please see the Characteristics and Risks of Standardized Options.
“Risk neutral,” in the context of investing, means that an investor focuses on the expected gains of a potential investment rather than its accompanying risks. This concept comes up frequently in options trading, as it’s one of the core tenets in how options are valued.
Risk neutrality is more of a valuation concept than a strategy. It’s often used by investment firms as a framework for the valuation of options and other complex derivatives.
Key Points
• A call debit spread involves buying a call option and selling another with a higher strike price, aiming for a bullish profit with limited risk.
• Entry requires purchasing a call and selling a higher strike call with the same expiration; exit by reversing these positions.
• Traders can use the call debit spread strategy to hedge against the risk of volatility collapse, which can negatively impact long call positions.
• Time decay affects the spread minimally when the asset price is near the middle of the strike prices.
• Early closure of profitable positions maximizes gains and reduces the risk of short call assignment and transaction fees.
What Is Risk Neutral?
Risk-neutral investors are concerned with the mathematical expected returns of an investment in options trading without incorporating risk factors into their valuation framework . When confronted with what may appear to be a risky decision versus the potential of a “sure thing,” risk-neutral investors are indifferent as long as the expected value of both options balance out.
Risk Neutral vs Risk Averse
Unlike risk neutrality, risk aversion considers risk and usually prefers certainty when comparing investment alternatives. While risk-averse investors consider expected value, they will also demand a “risk premium,” or additional benefit, for taking on additional risk in a transaction.
A risk premium refers to the additional return investors require to compensate for the uncertainty of potential losses. This premium reflects an investor’s tolerance for risk, and can influence their investment preferences.
Risk-neutral investors are generally indifferent between investment options with the same expected values, regardless of the accompanying risk factors. The concept of risk does not play into a risk-neutral investor’s decision-making process, and no risk premium is demanded for uncertain outcomes with equal expected values.
Most retail investors are risk averse, meaning they prefer investments with lower risk exposure, though they may still have some level of risk tolerance. Terms like “risk-adjusted returns” are common in the retail investment space, and entire doctrines in behavioral economics and game theory are built around the cornerstones of loss or risk-aversion.
The difference between risk-neutral vs. risk-averse investors can be illustrated with an example of probability-based decision-making.
Example of Risk Neutrality
To illustrate risk neutrality, consider a hypothetical situation with two investment options: one which involves a guaranteed payoff of $100, while the other involves a 50% chance of a $200 payoff or a 50% chance you receive nothing.
In our hypothetical scenario, the risk-neutral investor would be indifferent between the two options, as the expected value (EV) in both cases equals $100.
1. EV = 100% probability X $100 = $100
2. EV = (50% probability X $200) + (50% probability X $0) = $100 + 0 = $100
A risk-averse investor would factor in risk into their decision, however, making the two alternatives unequal in their decision-making framework. Given that the second option involves uncertainty (and therefore risk), the risk-averse investor would demand an added payoff to justify taking on any added risk.
Reframing the problem above, the risk averse investor would choose Option 1, given that both options return the same expected value, and Option 1 involves the greatest certainty.
On the other hand, the risk neutral investor would remain indifferent because, in their valuation framework, risk does not carry weight — only expected value matters. Since both options yield an EV of $100, they would not prefer one over the other, regardless of uncertainty.
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Risk Neutral Pricing and Valuation
Risk neutrality is used extensively in valuing derivative securities. It establishes a basis for determining theoretical equilibrium pricing between buyers and sellers in any transaction. Therefore, it’s an important aspect of options trading strategies.
Given that risk-averse investors demand a premium for taking on additional risk — and because each investor’s risk tolerance differs — pricing derivatives can become complex. This risk premium can present a problem from an analytical perspective; it introduces “noise” and complexity that can complicate the pricing of derivatives and other investments.
Investment valuation is typically based on the present value of expected future cash flows, a principle that applies across various risk preferences. Future cash flows are typically discounted using a required rate of return, which may be risk-free, risk-adjusted, or risk-neutral depending on the valuation approach.
In a risk-neutral framework, the discount rate remains consistent across investments, disregarding individual risk tolerance levels and risk premiums
To adjust for this complexity in derivatives trading, mathematicians and financial professionals may apply risk-neutral measures when pricing derivatives.
Understanding Risk Neutral Probability
Risk neutrality is used to find objective pricing for derivatives. Therefore, risk-neutral probability removes the noisy risk factor from calculations when finding fair value.
This differs from real-world, risk-based pricing, which introduces any number of security-specific or market-based factors back into the calculation. The downside of this “real-world probability” is that it makes calculating value an exceedingly complex exercise, as it requires fine-tuned adjustments for almost every unique factor that might affect an investment.
Risk-neutral probabilities allow investors to apply a consistent single rate towards the valuation of all assets for which the expected payoff is known. This simplifies the valuation process.
This is not to say that risk-aversion and other costs are not factored into calculations, however. Risk-averse investors would rarely choose to accept trades that don’t offer risk premiums over the long run.
Instead, risk-neutral probabilities serve as a foundation for valuation models, with additional risk factors incorporated when necessary.
The Takeaway
Identifying what type of investor you are is important before diving in. If you’re a risk-neutral investor, choosing between risky and non-risky investments will be based on expected values.
If you are risk averse in your options trading strategy, your investment opportunities will need to be assessed based on whether you are receiving a risk premium commensurate with the risk you perceive.
Investors who are ready to try their hand at options trading despite the risks involved, might consider checking out SoFi’s options trading platform offered through SoFi Securities, LLC. The platform’s user-friendly design allows investors to buy put and call options through the mobile app or web platform, and get important metrics like breakeven percentage, maximum profit/loss, and more with the click of a button.
Plus, SoFi offers educational resources — including a step-by-step in-app guide — to help you learn more about options trading. Trading options involves high-risk strategies, and should be undertaken by experienced investors. Currently, investors can not sell options on SoFi Active Invest®.
FAQ
Is risk neutral the same as risk free?
Risk neutral does not imply risk free. Risk neutral is simply a conceptual approach for evaluating trade offs without the impact of risk-factors.
Risk continues to exist in the context of each investment when evaluating tradeoffs; risk neutral simply suspends risk as a factor in the evaluation process.
What makes some companies risk neutral?
From a theoretical perspective, companies may behave in a risk-neutral manner by hedging their exposure through insurance, derivatives, or risk transfers. They can do this by purchasing insurance, buying financial derivatives, or transferring their risk to other parties. This allows them to focus on expected outcomes rather than the risk-related costs of those decisions.
Conceptually, shareholders may also want firms to make decisions in a risk-neutral manner, as individual investors can hedge risk exposure themselves by buying the shares of a number of other firms to diversify and offset these risk factors.
What is an example of risk neutral?
An example of risk neutral would be an individual who’s indifferent between a 100% chance of receiving $1,000, versus a 50% chance of receiving $2,000 (and a 50% chance of receiving nothing).
In both cases, the expected value would be $1,000, after calculating for both probability and return. This expected value would be what risk-neutral investors would focus on. By contrast, a risk-averse individual would choose the first option, as the outcome has more certainty (and less risk).
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Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
Disclaimer: The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.
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