Directional Trading

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.


Filed Under:

comments powered by Disqus
Hot Definitions
  1. Quanto Swap

    A swap with varying combinations of interest rate, currency and equity swap features, where payments are based on the movement of two different countries' interest rates. This is also referred to as a differential or "diff" swap.
  2. Genuine Progress Indicator - GPI

    A metric used to measure the economic growth of a country. It is often considered as a replacement to the more well known gross domestic product (GDP) economic indicator. The GPI indicator takes everything the GDP uses into account, but also adds other figures that represent the cost of the negative effects related to economic activity (such as the cost of crime, cost of ozone depletion and cost of resource depletion, among others).
  3. Accelerated Share Repurchase - ASR

    A specific method by which corporations can repurchase outstanding shares of their stock. The accelerated share repurchase (ASR) is usually accomplished by the corporation purchasing shares of its stock from an investment bank. The investment bank borrows the shares from clients or share lenders and sells them to the company.
  4. Microeconomic Pricing Model

    A model of the way prices are set within a market for a given good. According to this model, prices are set based on the balance of supply and demand in the market. In general, profit incentives are said to resemble an "invisible hand" that guides competing participants to an equilibrium price. The demand curve in this model is determined by consumers attempting to maximize their utility, given their budget.
  5. Centralized Market

    A financial market structure that consists of having all orders routed to one central exchange with no other competing market. The quoted prices of the various securities listed on the exchange represent the only price that is available to investors seeking to buy or sell the specific asset.
  6. Balanced Investment Strategy

    A portfolio allocation and management method aimed at balancing risk and return. Such portfolios are generally divided equally between equities and fixed-income securities.
Trading Center