What Is Directional Trading?
Directional trading refers to strategies based on the investor's view of the future course of something: either the overall financial market or a particular security. Their assessment of the direction will be the sole determining factor in whether the investor decides to sell or buy.
- Directional trading refers to strategies based on the investor's view of the future direction of the market.
- Investors can implement a basic directional trading strategy by taking a long position if the market, or security, is rising, or a short position if the security's price is falling.
- Directional trading requires the trader to have a strong conviction about the market's, or security’s, near-term direction, while being aware of the risks if prices move in the opposite direction.
- Directional trading is widely associated with options trading, which offers more flexibility and less risk than purchases of securities themselves.
Understanding Directional Trading
Directional trading essentially is a bet on the up or down movement of the market or a security. It is widely associated with options trading since several strategies can be used to capitalize on a move higher, or lower, in the broader market, or a particular stock. Investors can implement a basic directional trading strategy by taking a long position if the market, or security, is rising (or they think it will), or a short position if the security's price is falling.
Typically, directional trading in stocks needs a relatively sizeable 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. Overall, options offer much greater flexibility to structure directional trades as opposed to straight long/short trades in a stock or index.
While directional trading requires the trader or investor to have a strong conviction about the market, or security’s, near-term direction, they also need to have a risk mitigation strategy in place to protect investment capital if prices move in the direction that is counter to the trader's view.
Example of Directional Trading
Suppose an investor is bullish on stock XYZ, which is trading at $50, and expects it to rise to $55 within the next three months. The investor, therefore, buys 200 shares at $50, with a stop-loss at $48 in case the stock reverses direction. If the stock reaches the $55 target, it could be sold at that price for a gross profit, before commissions, of $1,000. (i.e., $5 profit x 200 shares). If XYZ only trades up to $52 within the next three months, the expected advance of 4% might be too small to justify buying the stock outright.
Options may offer the investor a better alternative to profiting from XYZ’s modest move. The investor expects XYZ (which is trading at $50) to move sideways over the next three months, with an upside target of $52 and a downside target of $49. They could sell at-the-money (ATM) put options with a strike price of $50 expiring in three months and receive a premium of $1.50.
The investor, therefore, writes two put option contracts (of 100 shares each) and receives a 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 the investor retains the premium of $300, less commissions. However, if XYZ trades below $50 by the time the options expire, the investor would be obligated to buy the shares at $50.
If the investor was extremely bullish on XYZ’s share price and wanted to leverage their trading capital, they could also buy call options as an alternative to buying the stock outright.
Types of Directional Trading Strategies
More sophisticated directional trading strategies that involve options use a combination of calls (the right to buy the underlying asset) or puts (the right to sell the asset). There are four basic types:
Bull calls: An optimistic play, when the investor thinks prices are rising. They create this by buying a call option with a lower strike price and sell a call option with a higher strike price.
Bull puts: Also a bet that the markets are on an upswing. It's similar to bull calls but uses put options instead. Investors buy a put with a lower strike price and sell a put with a higher strike price.
Bear calls: A pessimistic play, based on the belief that market prices will fall. Traders execute this by selling a call with a low strike price and buying a call with a high strike price.
Bear puts: Another way to bet on declining prices. Traders create bear puts by selling a put with a low strike price and buying a put with a high strike price.