Directional trading comprises a bunch of strategies exercised by traders based on their view of the future of the markets. This view could be in respect of the larger market altogether or a particular sector or a particular stock. As long as the trader has a view on the future of a security or an instrument, be it bullish or bearish, any strategy that he exercises will come within the purview of directional trading strategies.
Let’s break down the concept of directional trading strategies further.
What does directional trading involve?
Once the trader has made an assessment of the market landscape and arrived at an understanding of the future direction of the market, he can decide to buy or sell a particular security or share. In case, he believes that an XYZ security is likely to perform very well in the coming days, then he can purchase shares of that company (in other words, he can go long on the scrip) and wait for the share price to rise as per his expectations. On the other hand, if he is of the opinion that a company is likely to perform quite badly in the coming quarter, he can sell the shares of the company (or in other words, he can go short on the scrip) and wait for the company stock price to crash and purchase it once again when he feels that the stock is appropriately priced.
For the sake of simplicity, these directional trading strategies have been explained in the background of a share transaction, however, most of these trading strategies are executed in the derivatives market, especially, the options segment.
Directional trading in the options segment
As stated earlier, these strategies are predominantly executed in the options segment which comes under the derivatives market. Directional trading strategies are executed on the basis of the movement of a stock upwards or downwards. Directional trading strategies executed in the equity segment will have to register a strong and aggressive upwards or downwards swing for it to be profitable to the trader. However, the leverage associated with options trading helps make even small movements in the underlying stocks quite profitable for traders. The one great feature of directional trading strategies is that they can be attempted even if the expected movement in the underlying stock is not large. However, readers must note that derivatives such as futures and options are risky investment vehicles and traders must exercise caution and due diligence before trading in them. For market veterans, options offer great flexibility and elbow room in structuring transactions that can earn them potentially good profits even with small movements.
Illustration of a directional trading strategy
Let us suppose that a trader is bullish on a stock that is trading at Rs 50. He expects the stock price to move up in the coming days and hit the target of Rs 55. He has consequently purchased 200 equity shares of the company at Rs 50, with a stop loss of Rs 48 in case the stock reverses its direction. If the stock achieves its target of Rs 55, the trader can rejoice at his gross profit of Rs 1,000 which does not account for commissions and other taxes. However, if the stock only moves up to the price level of Rs 52, then the profit of the trader remains quite small and what’s worse the commissions and taxes payable on the transaction will diminish his profit all the more.
In such a case, trading in options is quite handy. In the above-mentioned scenario, let us assume that the trader expects the share to register a slight up movement from Rs 50 to Rs 52. In this scenario, the trader can sell the in-the-money option of the stock with the strike price of Rs 50 and pocket the premium. Let us assume that the trader sells two put options contracts of 100 shares each and pockets Rs 300(Rs 1.5*200). If the stock indeed does rise up to Rs 52 by the time of exercise of the option, the option will expire unexercised. In case it sinks below Rs 50 at the time of the expiry of the option, the trader will be obligated to buy the stock at Rs 50.
In case, the trader is bullish on the stock, he can also purchase call options to the stock to leverage his position with limited trading capital. However, even here caution is to be exercised before trading.
What are the different kinds of directional trades in the market?
Over the years, market veterans have devised a number of sophisticated and complex market trading strategies to target high returns while preserving their capital against sudden adverse market movements. Let us dig a little deeper into these strategies.
This trade is exercised when the trader believes that the market is in a bullish mode and expects the price of a stock to go up. Bull calls are executed by traders by buying a call option with a lower strike price and selling a call option with a higher strike price.
This trade is also put into play by traders when they are expecting a stock price to rise. The only difference is that traders use puts options in this strategy instead of calls. This strategy is executed by buying a put with a lower strike price and selling a put with a higher strike price.
This strategy is executed when traders feel that the market sentiment is bearish and that the stock price concerned is likely to suffer a fall. This strategy is created when the trader sells a call option with a low strike price and then buys a call option with a higher strike price.
This strategy works on the same lines as bear calls and is employed when traders wish to make a profit from a falling stock price. The one major difference in this strategy is that it uses puts instead of calls. It is created by selling a put option with a lower strike price and then buying a put option with a higher strike price.