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What is meant by Risk Neutrality?
There is always an inherent risk in all kinds of investments and options contracts are no different. When a trader invests money in options, he can be either a risk-taker or a risk-averse investor.
Risk Neutrality is a term used for traders who are indifferent to the risks of losing money. They just consider the final outcomes of the investments without taking care of what the other options of the investments are. Obviously, the gains for risk-neutral investors are higher, but the risk of losing money is also proportional to the risks taken by the risk-neutral traders.
The term "risk-neutral" is the opposite of "risk-averse", as the latter does not want to take any risk and looks for certainty in income from the investments.
The term "risk-neutral" is also different from "risk-seekers" because seekers invest in dangerous stocks that have a higher probability of going down but in the case the market is good, they may return much higher returns than normal stocks.
Example: Risk Neutral Vs Risk Averse
Suppose there are two investment options in front of a trader
Option 1 − Investment of INR 1000 with 100% certainty that will return 20% or INR 200 at the end of the year.
Option 2 − : Investment of INR 500 that it will return 20% or lose 20% after one year.
For the risk-averse investor, the first option is alluring because there is a certainty of return, while for the risk-neutral investor, both options are alike. Therefore, risk neutrality is a term that offers an idea where the focus on the results is neutral and it does not matter whether the profits or losses occur to the investment in options.
Risk Neutral Vs Risk Seeking
There is one more class of investors who are ready to take risks for larger gains. These investors do not care whether the options are risky and invest in them in search of more returns. These risk-seekers are different from risk-neutrals because the latter simply invests in instruments that do not have any specific outcomes attached to them, i.e., they may be profitable or loss-making whereas the risk seekers are sure that they are gambling with their money, as they invest in options that have more chances of incurring losses but in case they gain value, it will be maximum.
Therefore, risk neutrality is an options strategy where the risk-neutral investors take the risk of gaining from more volatile investments. The investments made may not make much sense, but risk-neutral traders believe that the risk-neutral stocks will offer higher returns in the future. Risk-seeking and risk-averse investors are two extremes that stay at two ends of the risk-neutral investments though.
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