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.
Quick Summary Points
- Directional options strategy is a strategy investors use to make money by betting on the direction of the market.
- The four types of strategies are bull calls, bull puts, bear calls, and bear puts.
- The strategies help decrease the cost of options, volatility, and risk, but also create smaller payoffs.
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.
The diagram below is an illustration of a bull call. The vertical axis represents the payoff, which is the profit minus price of premium and the horizontal axis is the price. The blue lines are the long and short position on a call option and the orange line is the payoff of the bull call depending on the price of the underlying asset. Since a bull call is a bet the price will increase, the payoff is higher when the price is high. The diagram also shows that when the price is low, the long call has a lower payoff than the bull call. However, the long call has more potential for higher payoff as the bull call’s payoff is caped after the price is the same as the K2 strike price.
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.
Similar to the bull call, the diagram below shows that the payoff is higher when the price is high. It also shows that a short put has a more extreme negative payoff when the price is low. By buying a long put option with strike price K1, the payoff is less extreme.
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.
As a bear call is a bet that the price of the underlying asset will fall, the diagram demonstrates higher payoff when prices are low. It also shows that the loss of the bear call, orange line, is capped. This takes away the risk of a short call, which can have unlimited loss depending on how high the price rises.
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.
As shown by the diagram below, the payoff is at the highest before the price of the underlying asset reaches the strike price K1. This fits in with the investor’s prediction and provides high payoffs when the price is low. The diagram also shows that the bear put’s payoff shown by the orange line decreases steadily with the rise in price. However, it is not as low as having just a long put option as the short position on another put option provides a positive payoff.
Why does it matter?
Directional trading strategies help investors limit their risk, decrease costs, and predict the cash flow with greater accuracy. Understanding directional strategies also help investors create more complex strategies. These strategies combine bull spreads and call spreads and bet on the volatility of the underlying asset.
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