I like directional trading—heck, I even blog about it from time to time—but for the most part directional options trading is a hobby, something I do for fun with my FU money. There is nothing better than picking a direction, applying a leveraged bet via options or futures, and watching that trade take off. I have risked $300 in the morning and closed the day with $2000; that’s a pretty big high. And when that happens, like a drug addict chasing a high each morning you wake up thinking you can turn $300 into $2000 again. Directional trading is exciting and can earn you a few bucks, but it very rarely turns into a long-term income-producing strategy.
Isn’t All Options Trading Directional?
In my opinion directional options trading can be useful, but more on that later. Let’s first look at the type of trades I prefer. I seek statistical and probability-based trades, such as my Baseline Strategy. I want to deploy trading strategies that do not require me to form an opinion on anything. My trades are based on the statistical chances that I will profit. For example:
During any 30-day period from 1993 through 2014 the SPY (the Exchange Traded Funds, or ETFs, tracking the S&P 500) closed down 5% or more 11% of the time
Did you know that? Based on this simple fact I can build strategies that focus on profiting when the SPY does anything other than drop 5%. That is, the SPY dropping 4%, rising 10%, or staying flat all lead to profit. I know, based on past performance, that 89% of the time I will profit and 11% of the time I will lose money. I tend to trade options using credit spreads in order to take advantage of this statistical aspect of the market.
This example is just one of tons of statistical opportunities in the market where options are an amazing tool for profit. I want to highlight the fact that my trading strategy is not based on news events, earnings reports, and the like. In the context of my statistical based trading strategy I simply do not care about what the market will do going forward. I have no directional bias.
When Is Directional Options Trading a Good Idea?
Just remember, these are one man’s thoughts. Tons of people do very well with directional trading. I submit, however, that these people have stressful lives and rarely see consistent (well, more consistent) returns. Typically only a select few survive—many directional trades go bust. But as I said, I do think there is value in directional trading. Though I tend to think directional trading should be done with small amounts of money (except in the case of buy and hold). Here are some cases when directional trading is a good idea:
- To stay in engaged. At times I like to day trade the S&P 500 either through SPY options or ES futures contracts. Though I do have a strategy that is back tested, at the end of the day I am just making educated guesses about market direction based on signals I find useful. My core strategies are pretty boring day in, day out so I do some directional trading to stay excited, keep my juices flowing.
- To hedge. Recently I thought the market might take a turn for the worse, having gotten over the Trump Bump. So I used a small amount of money to purchase some VXX calls, betting that volatility would increase fast (which typically happens when the market tanks). In the SPY example earlier 11% of the time a trader should expect to lose money, and I was guessing this might be one of those times so I tried to hedge my losses. I don’t do much hedging, but when I do I often use a directional trade.
- To buy and hold. Mainly done with stock, in the buy and hold arena I subscribe to the Warren Buffett way of thinking. If you buy good companies, sometime in the future they will be worth more. So buy and hold a long-term directional investment.
Options Trading Has Changed Everything
If non-directional trading is so smart why has directional trading been the core strategy on Wall Street for generations? Options products expanded just 10 years ago—once upon a time major indexes only offered monthly options. These days we have weekly options on almost every stock, ETF, and futures contract traded. Also, technology allows us to easily find statistical opportunities in the market along with the trades to take advantage of them. Lastly, high-frequency trading has created enough liquidity for our trades to get filled at profitable returns (perhaps more on that in a later blog post).
Directional trading is not the only way to make money in the market using options. I encourage all directional traders to spend sometime looking at statistical based options trading strategies.
Related Topics: Directional Options Trading
