Directional trading refers to strategies which are focused on the investor’s view of the market’s future direction. It will be the sole determinant of whether the buyer wants to sell or purchase the safe.
1. The Definition of Directional Trading
Investors can implement a simple directional trading strategy by taking a long standing if the stock, or security, is rising or a short standing. It is used if the price of the security is dropping.
If rates go in the opposite direction of the trader’s view, a trader must also have a risk reduction plan in place. Therefore, it will protect its investment capital.
Directional trading requires a deep conviction from the trader about the near-term direction of the market, or stability. Meanwhile, the investor should be mindful of the risks, if prices shift in the opposite direction.
2. The Example of Directional Trading
Assume an investor is optimistic on stock XYZ. Then, the trading is at $50. After that, he/she expects to rise to $55 in the next three months. Next, the investor purchases 200 shares at $50, with a stop-loss at $48 if the stock reverses course.
If the stock hits the target of $55, it will be priced at that price for a gross profit of $1,000, including commissions. (for example the profit $5 x 200 shares). If XYZ trades only up to $52 over the next three months, the predicted 4% gain could be too low to justify purchasing the stock outright.
Options will provide the investor with a better option to benefit from the modest step XYZ has made. The investor expects XYZ (which trades at $50) to move sideways over the next three months. $52 for upside target. Meanwhile, $49 are for downside target.
They will sell at – the-money (ATM) put options with an expiring $50 strike price in three months. And also, they earn a $1.50 premium. Therefore, the investor signs two contracts for put options (of 100 shares each) and receives a gross premium of $300 (i.e. $1.50 x 200).
If XYZ increases to $52 by the time the options expire in three months, they will expire untrained. In other words, the investor keeping the $300 premium and minus commissions. However, if XYZ trades under $50 by the time the options expire, the buyer will be forced to buy the stock at $50.
If the investor was incredibly bullish at the share price of XYZ and decided to maximize their trading resources, they could also purchase call options as an alternative to purchasing the stock straight away.
Overall, options offer much more flexibility in structuring positional trades than in direct long / short trades in a stock or index.