Directional Trading: Overview, Example, and Types

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.

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 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.

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.

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.

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 selling 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.

The Bottom Line

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.

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.