Directional Trading Definition

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Directional Trading Definition

What Is Directional Trading?

Directional trading refers to tactics based on an investor’s prediction of the future direction of something, such as the broader financial market or a specific asset. The investor’s decision to sell or purchase will be solely based on their appraisal of the direction.

Key Takeaways

  • Directional trading refers to methods that are based on the investor’s prediction of the market’s future direction.
  • A simple directional trading strategy may be used by investors by holding a long position if the market, or security, is rising, or a short position if the security’s price is decreasing.
  • Directional trading necessitates the trader having a strong belief in the market’s or security’s near-term direction while also being mindful of the hazards if prices go in the other way.
  • Directional trading is often related with options trading, which provides more flexibility and lower risk than stock buying.

Understanding Directional Trading

Directional trading is simply a wager on whether the market or an asset will go up or down. It is often related with options trading since numerous tactics may be utilized to profit from a move up or down in the wider market or a specific stock. A simple directional trading strategy may be used by investors by holding a long position if the market, or security, is rising (or they believe it will), or a short position if the security’s price is decreasing.

Typically, directional trading in stocks requires a somewhat large shift in order for the trader to pay fees and trading expenses while still profiting. However, because of the leverage provided by options, directional trading may be tried even if the predicted change in the underlying stock is not projected to be significant. Overall, options provide much more flexibility in structuring directional bets than simple long/short trading in a stock or index.

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While directional trading necessitates a strong conviction about the market’s or security’s near-term direction, the trader or investor must also have a risk mitigation plan in place to preserve investment money if prices go in the opposite direction of the trader’s opinion.

Example of Directional Trading

Assume that investor believes that stock XYZ, which is now priced at $50, would grow to $55 during the next three months. As a result, the investor purchases 200 shares at $50, with a stop-loss of $48 in case the price reverses course. If the stock achieves the $55 objective, it may be sold at that price for a $1,000 gross profit before fees. (For example, $5 profit times 200 shares). If XYZ only moves up to $52 in the following three months, the predicted gain of 4% may be insufficient to warrant purchasing the stock entirely.

Options may provide the investor with a better option to capitalize from XYZ’s little movement. XYZ (now trading at $50) is expected to trade flat over the next three months, with an upside goal of $52 and a downside target of $49. They may obtain a $1.50 premium by selling at-the-money (ATM) put options with a strike price of $50 that expire in three months.

As a result, the investor executes two put option contracts (each for 100 shares) and obtains a gross premium of $300 (i.e., $1.50 x 200). If XYZ rises to $52 before the options expire in three months, they will expire unexercised, and the investor will keep the $300 premium, minus fees. If XYZ trades below $50 by the time the options expire, the investor is compelled to purchase the shares at that price.

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If the investor was highly positive on XYZ’s share price and wanted to leverage their trading money, they could also purchase call options instead of purchasing the shares outright.

Types of Directional Trading Strategies

More advanced option-based directional trading methods combine calls (the right to purchase the underlying asset) and puts (the right to sell the asset).There are four fundamental types:

Bull calls: An optimistic bet in which the investor believes that prices will rise. They do this by purchasing a lower strike price call option and selling a higher strike price call option.

Bull puts are also a wager that the markets are on the rise. It is similar to bull calls, but instead employs put options. Investors purchase a lower strike price put and sell a higher strike price put.

Bear calls: A bearish gamble that assumes market prices will decrease. Traders carry out this strategy by selling a low-strike call and purchasing a high-strike call.

Bear puts are another approach to speculate on falling prices. Traders produce bear puts by selling a low strike price put and purchasing a high strike price put.

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