Directional Trading

AAA

DEFINITION of 'Directional Trading'

Trading strategies based on the investor’s assessment of the broad market or a specific security’s direction. Directional trading can mean a basic strategy of going long if the market or security is perceived as heading higher, or taking short positions if the direction is downward. However, the term is more widely used in connection with options trading, since a number of strategies can be used to capitalize on a move higher or lower in the broad market or a particular stock. While directional trading requires the trader to have a strong conviction about the market or security’s near-term direction, the trader also needs to have a risk mitigation strategy in place to protect investment capital in the event of a move to the opposite direction.

INVESTOPEDIA EXPLAINS 'Directional Trading'

Directional trading in stocks would generally need a fairly large move to enable the trader to cover commissions and trading costs and still make a profit. But with options, because of their leverage, directional trading can be attempted even if the anticipated movement in the underlying stock is not expected to be large.

For example, a trader (call him Bob) may be bullish on stock XYZ, which is trading at $50, and expects it to rise to $55 within the next three months. Bob could therefore buy 200 shares at $50, with a possible stop-loss at $48 in case the stock reverses direction. If the stock reaches the $55 target, Bob could sell it at that price for a gross profit (before commissions) of $1,000.

What if Bob expected XYZ to only trade up to $52 within the next three months? In this case, the expected advance of 4% may be too small to justify buying the stock outright. Options may offer Bob a better alternative to making some money off XYZ.

Let’s say Bob expects XYZ (which is trading at $50) to trade mainly sideways over the next three months, with upside to $52 and downside to $49. One possible option trade is for Bob to sell at-the-money (ATM) puts with a strike price of $50 expiring in three months, for which he could receive premium of $1.50. Bob therefore writes two put option contracts (of 100 shares each) and receives gross premium of $300 (i.e. $1.50 x 200). If XYZ does rise to $52 by the time the options expire in three months, they will expire unexercised and Bob’s gain is the premium of $300 (less commissions). However, if XYZ trades below $50 by the time of option expiry, Bob would be obligated to buy the shares at $50.

If Bob was very bullish on XYZ and wanted to leverage his trading capital, he could also buy call options as an alternative to buying the stock outright. Overall, options offer much greater flexibility to structure directional trades as opposed to straight long/short trades in a stock or index.

RELATED TERMS
  1. Stock

    A type of security that signifies ownership in a corporation ...
  2. Trading Floor

    The floor where trading activities are conducted. Trading floors ...
  3. Short (or Short Position)

    1. The sale of a borrowed security, commodity or currency with ...
  4. Long (or Long Position)

    1. The buying of a security such as a stock, commodity or currency, ...
  5. Sell

    The process of liquidating an asset in exchange for cash. The ...
  6. Trading Account

    1. An account similar to a traditional bank account, holding ...
RELATED FAQS
  1. Are investments in the chemicals sector appropriate for ethical investors?

    Generally speaking, ethical investors shy away from chemical manufacturers and companies that have perceived negative chemical ... Read Full Answer >>
  2. Is the drugs sector better suited for active or passive investment?

    Active management and passive management represent two vastly different approaches to investing. Active investors keep their ... Read Full Answer >>
  3. What makes the chemicals sector attractive to value investors?

    The chemicals sector is attractive to value investors because it is a capital-intensive sector that can become grossly undervalued ... Read Full Answer >>
  4. How does a pension income drawdown work?

    While there are similar drawdown plans in the United States, a pension income drawdown plan most commonly refers to a specific ... Read Full Answer >>
  5. What is the most important section in an investment company's prospectus?

    It is important for investors to examine all information contained within an investment company’s prospectus. However, the ... Read Full Answer >>
  6. What is a barbell fixed-income strategy?

    A barbell fixed-income strategy is an investment strategy in which a portfolio is comprised of long- and short-term bonds. ... Read Full Answer >>
Related Articles
  1. Investing Basics

    Investment Strategies For Volatile Markets

    Read on to learn some investment strategies when the volatility is high.
  2. Active Trading

    Which Direction Is The Market Heading?

    The easy and underused NYSE Bullish Percent Index provides insight into market conditions.
  3. Active Trading

    Adjusting Day Trading Strategies For Different Market Conditions

    Being a successful trader means knowing when to play the market and how. Find out what strategies will have you on top.
  4. Forex Education

    Confirm Forex Momentum With Heikin Ashi

    Heikin Ashi smooths trends and makes them easier to identify.
  5. Options & Futures

    Trade Forex With A Directional Strategy

    Opening long or short positions to cash in on a trend is one of the simplest ways to trade forex.
  6. Trading Strategies

    Day Trading Strategies For Beginners

    From picking the right type of stock to setting stop-losses, learn how to trade wisely.
  7. Technical Indicators

    Using Technical Indicators To Develop Trading Strategies

    Unfortunately, there is no perfect investment strategy that will guarantee success, but you can find the indicators and strategies that will work best for your position.
  8. Options & Futures

    Forecasting Market Direction With Put/Call Ratios

    Options are not only trading instruments but also predictive tools that can help us gauge the feelings of traders.
  9. Forex Education

    Create Your Own Trading Strategies

    Do-it-yourself trading can be very rewarding - both psychologically and for your wallet.
  10. Forex Education

    Finding Market Movement With The ADX

    Take a closer look at this indicator, which refines your insight into the strength of a prevailing trend.

You May Also Like

Hot Definitions
  1. Butterfly Spread

    A neutral option strategy combining bull and bear spreads. Butterfly spreads use four option contracts with the same expiration ...
  2. Unlevered Beta

    A type of metric that compares the risk of an unlevered company to the risk of the market. The unlevered beta is the beta ...
  3. Moving Average - MA

    A widely used indicator in technical analysis that helps smooth out price action by filtering out the “noise” from random ...
  4. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
  5. Productivity

    An economic measure of output per unit of input. Inputs include labor and capital, while output is typically measured in ...
  6. Variance

    The spread between numbers in a data set, measuring Variance is calculated by taking the differences between each number ...
Trading Center