Directional trading is a collection of strategies that traders use to trade based on their outlook of the market's future. This could be a view of the entire market, a specific sector, or a stock. Any strategy he uses to trade directionally will be considered as long as he has a view about the future of the security or instrument, whether it is bullish or bearish.
Let's take a closer look at directional trading strategies.
After assessing the market landscape and determining the future direction of it, the trader can make a decision to either buy or sell that security or share. If he thinks that XYZ security will perform well in the next few days, he can buy shares of the company. In other words, he could go long on the scrip and wait for the share to rise according to his expectations. If he believes that a company will perform poorly in the next quarter, he could sell shares of that company. Or, he could go short on the stock and wait for it to crash before buying it again once it is rightly priced.
These directional trading strategies were explained in the context of a share transaction. However, most of them are executed in the derivatives marketplace, particularly the options segment.
These strategies are mainly executed in the options market, which is also covered by the derivatives market. The movement of a stock up or down is the basis for directional trading strategies. To be profitable, directional trading strategies in the equity segment must register an aggressive upwards and downwards swing. Options trading makes even small movements in underlying stocks very profitable for traders due to the leverage. One of the best things about directional trading strategies, however, is their ability to be used even when the expected movement in an underlying stock may not be large. But traders should be aware that derivatives like options and futures can be risky investments and they must be used with caution. Options offer market veterans great flexibility and elbow space in structuring transactions that can yield them potential good profits, even for small movements.
Let's say that a trader believes that a stock is worth Rs 50. He anticipates that the stock price will rise in the next few days to reach the target of Rs 55. The trader purchased 200 shares of equity at Rs 50 and a stop loss limit of Rs 48 to protect himself in the event that the stock's direction changes. The trader will be able to enjoy a gross profit of Rs 1000 if the stock reaches its target price of Rs 55. This does not include commissions or other taxes. If the stock does not rise to Rs 52, the trader's profit will be very small. Furthermore, the transaction fees and commissions will reduce his profit even more.
Trading in options can be very useful in such cases. Let's say that the trader expects that the share will see a slight increase in value from Rs 50 to R 52. The trader could sell the stock's in-the-money option at Rs 50 to pocket the premium. Let's say the trader sells 100 shares of put options and makes Rs 300 (Rs 1.5*200). The option will not be exercised if the stock does indeed rise above Rs 52 at the time of exercising it. If the stock falls below Rs 50 by the expiry date of the option, the trader is obligated to purchase the stock at Rs 50
If the trader is bullish about the stock, he may also buy call options to the stock in order to leverage his position using limited trading capital. Trading is still a risky proposition.
Market veterans have developed a variety of complex and sophisticated market trading strategies over the years to maximize their returns and protect their capital from sudden market fluctuations. These strategies are more in-depth.
When the trader believes the market is in bullish mode and expects a stock's price to rise, this trade is executed. Bull calls can be executed by traders who buy a call option at a lower strike price, and then sell a call option at a higher price.
When traders expect a stock to rise, they also use this trade. This strategy is different because traders use calls instead of options . This strategy involves buying a put at a lower strike price, and then selling it at a higher price.
This strategy is used when traders believe that market sentiment is bearish, and that the stock price is likely to fall. This strategy involves the sale of a call options at a low price, followed by the purchase of a call option at a higher price.
This strategy is similar to bear calls, and can be used when traders want to profit from falling stock prices. This strategy uses calls instead of puts. This strategy is made by selling a put options with a lower strike and then purchasing a put option that has a higher strike.