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.

BREAKING DOWN '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.

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