What is a directional trade?
In general, a directional trade is a trade in which you are betting on a particular direction (up or down) in the movement of price of a security. If you are right and the security goes in the direction you chose, you make a profit. If it goes the other way, you lose. If it stays at the same price where you have bought it, you neither make money nor lose.
Bullish and bearish option trades
You have two basic possibilities. You can speculate on an increase in a security price – in this case you say you are long or bullish. Or you can speculate on a fall in a security price and you say you are short or bearish. Let’s look at examples of bullish and bearish directional trades with stocks.
Example of bullish directional trade: Alcoa
Let’s say you expect global commodity demand and commodity prices to rise in the near future and you particularly like aluminium. You pick Alcoa, the large aluminium producer traded on the New York Stock Exchange. You buy 2,000 shares for 25 dollars each (it costs you 50,000).
Half a year later commodities including aluminium are much higher and so is Alcoa share price. You now sell your 2,000 shares for 40 and make a profit of 30,000 dollars on your trade. You have just made a successful directional trade on the bullish side.
Now you may think something like: but it is just normal buying and selling stocks… and you’re right, it is. Directional trades are what most people do in the markets.
Example of bearish directional trade: Lehman Brothers
Now imagine you somehow got a strong feeling that a big investment bank, let’s call it Lehman Brothers for example, could get to serious trouble in the coming weeks and may even go bankrupt. In such case, its stock would likely drop like a stone. You want to profit on this idea and you short the Lehman Brothers stock. You borrow 1,000 shares from your broker and sell them in the stock market for 50 dollars each.
Few weeks later, your idea gets proved right. There are many billions in “toxic” assets on the highly leveraged Lehman’s balance sheet, rumors are increasing, hedge funds are shorting alongside you, and the stock is dropping. Even the Fed which usually bails out everybody who is big enough, turns back this time and Lehman files for bankruptcy.
The stock you have sold short is now trading somewhere around 1 dollar. You buy back the 1,000 shares for 1 dollar each and you have just made 49,000 on this trade (50 less 1 is 49, times 1,000 shares). You have just made a successful directional trade, this time betting on the bearish or short side. The key to making profit was that the security you were trading moved in the direction you chose (down). If Lehman stock stayed at 50, you would have made nothing. If it moved up to 60, you would have lost money.
Directional trades are nothing new
In sum, buying and selling stocks, the most common thing people do when they are “trading” or “investing” (however you call it), is placing directional trades, as you always need the stocks to move up or down to make a profit or loss.
Now you are probably thinking that you have not learned anything new by reading this article. You might have only learned that buying and selling stocks is also called directional trades.
Directional trades with options
The term directional trade gets more important in the world of options. Besides directional trades, you can also make non-directional trades with options. Also the words like bullish, bearish, long, and short get more complicated.
Furthermore, unlike stocks directional trades with options don’t usually have the linear relationship between the (underlying) asset’s price movement and your profit or loss, as there is another part in the equation: the time value. Read more about directional trades with options.