Direction

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:

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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.

Experienced investors will base their directional trading on technical indicators and industry news, rather than on an emotional feeling about the market. They also will put risk mitigation strategies in place to limit losses in case the market doesn't move as expected.

The main risk in directional trading is that the investor is wrong about how the market will move and loses money on a trade. Having a risk mitigation strategy to minimize losses, such as putting a stop-loss order in place, is an important part of directional trading.

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Directional trading strategies are based on an investor's view of how the market will move, either more broadly or for a single security. The investor will take a long position if they expect the market to rise or a short position if they expect it to fall. This strategy is often associated with options trading since options are more flexible and less risky than purchasing the underlying securities.

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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.

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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.

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Directional trading is a real investing strategy if it is done with a strategic mindset. An investor who sells and buys purely based on their emotional feeling about prices isn't using an investing strategy, especially if they aren't using any risk mitigation strategies. However, careful traders can base their directional trading strategy on technical indicators about the broader market or individual securities, as well as use risk mitigation strategies to minimize potential losses.

Options offer much greater flexibility for structuring 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 a direction that is counter to the trader's view.

Directionality

Katrina Ávila Munichiello is an experienced editor, writer, fact-checker, and proofreader with more than fourteen years of experience working with print and online publications.

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.

Typically, directional trading in stocks needs a relatively sizeable move to enable the trader to make a profit while covering commissions and trading costs. 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.

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.

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 for a particular stock. Investors can implement a basic directional trading strategy by taking a long position if a security's price is rising (or they think it will), or a short position if the security's price is falling.

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The main advantage of buying options is that investors have a high potential for profit while losses are limited to the option's premium. They are useful as a source of leverage and a way to hedge risk. However, this advantage can also be a disadvantage because the option can expire without moving enough to be in-the-money, which leaves it worthless.