Directional Vs Non Directional Trading

Investment firms, fund managers and independent traders all rely on the right choice of trading strategy to ensure good market decisions. A number of factors — such as return, risk and timeframe — ultimately determine their choices. Whether they go for directional or non-directional strategies, they need to have specific levels of market knowledge as well as awareness of trading requirements. Both directional and non-directional trading strategies come with their share of pros and cons.

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 because 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).

Straddles and strangles are nondirectional option strategies that can profit either from a significant market move, up or down, of the underlying security (aka underlier), or if the price of the underlier only moves sideways. When 1st set up, straddles and strangles are deemed delta-neutral, because the positive delta of the call offsets the negative delta of the put. Delta is simply a measurement of the sensitivity of price changes of the options as the price of the underlier changes. So small changes in the price of the underlier do not significantly change the value of the nondirectional option position. Straddles and strangles are also considered volatility strategies, because the long positions profit when volatility is high, while the short positions profit when volatility is low.

Complexity

When it comes to complexity, directional strategies have the edge. Execution is simple and flexible, which means novice as well as experienced investors and traders can readily understand and follow them. Directional trading strategies follow a general rule of thumb: go long in an uptrend, short in a downtrend. This reduces these strategies' automation and technical analysis skill requirements considerably. Conversely, a good non-directional strategy requires automation, plenty of market knowledge, careful money management, and clear, predefined (but loose) trading rules — no guesswork, no rules of thumb. This is generally why expert traders and big investors are the ones that resort to non-directional strategies.

Risk

There is a good reason behind the complexity of non-directional strategies, and that reason lies partly in calculated diversification, a risk-minimizing technique. While directional strategies do allow for basic risk-minimizing tactics — such as stop losses and position offsetting — the options can still be severely limited. Also, the higher level of automation and predefined trading rules involved in non-directional strategies minimizes human interference and emotion, contributing to risk reduction. As for the potential for profit, non-directional strategies can be far more stable, as they depend on the expected volatility of underlying stock prices, rather than on whether they go up or down.

Applicability

Directional trading strategies cover a wider range of financial instruments than non-directional strategies. They are not merely for stocks and bonds; options, funds, currencies, futures, and commodities also may be handled using directional strategies. However, most directional trading strategies are nevertheless limited by the fact that they can only be safely practiced whenever the market is trendy.