What are directional trading strategies?
Directional trading strategies are strategies that bet on the up or down movement of the market. For example, if an investor believes the market is rising, they would take a long position. On the other hand, if an investor believes the prices will drop, then they will take a short position.
Directional trading strategies can be used simultaneously to create bets on volatility. This includes a straddle, strangle, and box spread strategy.
Understanding Directional Trading Strategies
When a trader indulges in trading and investing, based on the sole indicator of the direction of a stock according to a trader’s view of where the stock will go, the trading technique is called directional trading. Simply put, the trader is essentially determining a trade by betting on the upward or downward movement of markets, or of a specific security.
This trading strategy is broadly linked with options trading. This is due to the fact that many strategies can be utilized to capitalize on higher or lower moves, either in the wider market or a given stock. A basic directional trading strategy can be put into action by traders taking a long position if they find that the markets or any specific security is rising. On the other hand, they hold a short position if they find the markets are falling (or a security is).
Types of directional trading strategies
Trading strategies use either calls or puts. First, investors predict the movement of the market. Next, investors can create spreads by buying and selling options at different strike prices. Doing so will help decrease the risk and cost.
Investors create bull calls when they think the markets are good and will increase in price. They create this by buying a call option with a lower strike price and sell a call option with a higher strike price. When buying the call option, investors will have to pay a premium.
The premium is higher for options with a low strike price because it has greater value. Since buying a call option can be expensive, investors can choose to sell a call to collect a premium. By doing so, they create a bull call.
Bull put is also a bet that the markets are good and prices will increase. It is similar to bull calls but uses put options instead. Investors can create bull puts by buying a put with a lower strike price and selling a put with a higher strike price.
A bull put will have lower loses in comparison with a long put when prices fall. However, it also caps the earnings of the option. Thus, the cash flow is less volatile.
Bear call is based on the belief that market prices will fall. Investors or traders create this by selling a call with a low strike price and buying a call with a high strike price. Much like other directional strategies, the loss and gain of the option are limited.
However, the reward to the strategy is that there is less volatility. If prices end up increasing, an investor with a bear call will suffer fewer losses than an investor with a call option.
Similar to bear calls, bear puts create a profit when the market prices fall. Investors create bear puts by selling a put with a low strike price and buying a put with a high strike price. A bear put is cheaper than just buying a put option and decreases volatility. Since an investor is selling a put option, they can collect a premium to offset the cost of buying a put option with a high strike price.
Since a put option gives the buyer the ability to sell the underlying asset at a strike price, the option with a higher strike price is more valuable as it gives the buyer more income.