Directional Trades with Options
Directional and non-directional option trades
Maybe you have already heard about an option trade being directional or non-directional. What does it mean? In short, this distinction is about how much the trade is exposed to movement in price of the underlying security. This article explains directional trades. Here you can find the second part concerning non-directional option trades.
Bullish and bearish trades with stocks
Directional trades are the most common things people do in the markets. You have two basic possibilities. You can speculate on an increase in an asset’s price – in this case you say you are bullish. Or you can speculate on a fall in an asset’s price and you say you are bearish.
Here you can read about directional trades with stocks, which is pure and simple buying and selling of stocks. When you expect a stock to rise (you are bullish), you buy it and if you are right, you make money. When you expect a stock to fall (you are bearish), you sell it short and if you are right, you make money. If you are wrong and the stock goes in the other direction, you lose money. If the stock stays at the same level, you neither make nor lose any money. This is not always true with options as you will soon see.
Directional trades with options
You can place similar directional trades using options. In other articles we have explained why calls tend to increase in price when the underlying stock goes up, while puts tend to appreciate when the underlying goes down. So instead of buying the underlying stock, you buy a call, which is an example of a directional trade with bullish bias. Or instead of selling the underlying stock short, you can buy a put option, which is a directional trade with bearish bias, as a put increases in price when the underlying asset goes down.
Directional trades with options vs. directional trades with stocks
When you make directional positions with stocks, bonds, and other securities which don’t have the optionality and time value embedded in them, the relationship between the asset’s price and your profit or loss is linear and very simple. Stock goes up by 5, you hold 1,000 shares, and you make 5,000 dollars. Stock goes down by 3 dollars and with 1,000 shares you lose 3,000 dollars.
Options have time value and as a result the relationship between an option’s market price (and therefore your profit or loss) and the market price of the underlying asset is usually non-linear.
Underlying stock’s price and long call profit and loss
Let’s say you buy a call option, which is a bullish position, as call options appreciate when underlying asset rises. But unless the call is deep in the money (and has only little time value), the amount by which the call option will rise is not equal to the amount by which the underlying stock rises.
In the money long call
If a call option is in the money, its intrinsic value increases by the same amount as the underlying stock increases. But at the same time, as the option is getting deeper in the money, its time value declines (see why). As a result, the rise in the call option’s total market price is smaller than the increase in the underlying stock’s price.
This mechanism also works to the other side. If the underlying stock falls, the call option’s intrinsic value falls at the same rate, but its time value increases as the option is getting closer to the money. As a result, the fall in the option’s market price is slower than the fall in the underlying stock’s price.
Out of the money long call
If the underlying stock falls further and the option gets out of the money, its time value starts to decrease again (the further out of the money, the lower time value). But now the intrinsic value is already zero and it can’t fall further. As a result the option’s total market price moves only due to its time value, which is (with other factors like time and volatility being constant) typically slower than the underlying stock’s price.
Long call and long put
In sum, profit or loss of a long call position changes in the same direction as the underlying stock’s price, but usually at a slower pace. The greater share time value has on the option’s total market price, the greater the difference (the slower the pace). Deep in the money options move almost as fast as the underlying, while out of the money options move very slowly.
This is also valid for put options, only the direction is the opposite (put option appreciates when underlying stock falls).
The relationship between the underlying stock’s price changes and the option’s price changes is measured by the well known Greek letter delta.
Other factors influencing profit and loss
Besides the option’s moneyness (in the money vs. out of the money and by how much), an option’s time value is also influenced by other factors like time to expiration, volatility, or interest rates.
Directional option trades are called so because the factor of moneyness and the underlying’s price movement is usually the most significant (it is the reason why we make the trade). Nevertheless, the other factors usually still have some impact. For example if you buy a call option and the underlying stock’s price does not move at all, the option’s time value will probably decrease over time and you will make a loss, even when the underlying has not really gone against you.
Single option directional positions
Buying a call option (long call) or buying a put option (long put) are the two simplest directional positions you can create with options. Besides, you can also sell a call (short call, a bearish position) or sell a put (short put, a bullish position).
It is important to know the terminology and be aware of the difference between movement in price of an option and movement in price of its underlying. Unlike with stocks, long does not always mean bullish and short does not always mean bearish with options (read more here).
Directional positions using multiple options
Besides trades with single options there are also many different option spreads (like bull call spread, bull put spread, bear put spread, or bear call spread) and even more complicated combinations of multiple options, which in sum create a bullish or bearish exposure to the underlying security.