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. Sell

    The process of liquidating an asset in exchange for cash. The ...
  2. Stock

    A type of security that signifies ownership in a corporation ...
  3. Short (or Short Position)

    1. The sale of a borrowed security, commodity or currency with ...
  4. Trading Account

    1. An account similar to a traditional bank account, holding ...
  5. Trading Floor

    The floor where trading activities are conducted. Trading floors ...
  6. Long (or Long Position)

    1. The buying of a security such as a stock, commodity or currency, ...
Related Articles
  1. Thinkstock|Collection Mix: Subjects
    Investing Basics

    Investment Strategies For Volatile Markets

  2. Active Trading

    Which Direction Is The Market Heading?

  3. Active Trading

    Adjusting Day Trading Strategies For ...

  4. Forex Education

    Confirm Forex Momentum With Heikin Ashi

Hot Definitions
  1. Capitulation

    When investors give up any previous gains in stock price by selling equities in an effort to get out of the market and into ...
  2. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  3. Conduit Issuer

    An organization, usually a government agency, that issues municipal securities to raise capital for revenue-generating projects ...
  4. Financing Entity

    The party in a financing arrangement that provides money, property, or another asset to an intermediate entity or financed ...
  5. Hyperinflation

    Extremely rapid or out of control inflation. There is no precise numerical definition to hyperinflation. Hyperinflation is ...
  6. Gross Rate Of Return

    The total rate of return on an investment before the deduction of any fees or expenses. The gross rate of return is quoted ...
Trading Center