DEFINITION of Directional Trading
Directional trading refers to trading strategies based on the investor’s assessment of the broad market or a specific security’s direction. 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 prices are falling.
BREAKING DOWN Directional Trading
Directional trading is widely associated 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 if prices move in the opposite direction.
Directional trading in stocks needs a relatively 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.
Directional Trading Example
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. Overall, options offer much greater flexibility to structure directional trades as opposed to straight long/short trades in a stock or index. (To learn more, see: A Guide of Options Trading Strategies for Beginners.)