Directional and Non-Directional Trading

By: Chris Verhaegh

The following is an excerpt from Chris Verhaegh's The PULSE System

Our core option trading strategies break down into two main categories: Directional trading and Non-Directional trading.  We will use Directional trading when we have a bias on which direction a stock is likely to move.  We use Non-Directional trading when we know a stock is going to move, but we have no bias on which direction, or when the Reward factor is not lopsided to one particular direction.

Directional Bias

If a stock meets our criteria and we have good indicators – Fundamental and/or Technical – giving us a hard bias in one direction, then we apply our Directional strategy.  There are a wealth of Directional strategies out there.  We generally only employ two: Calls and Puts.  Nothing complicated, just buying a Call if our Directional bias is Bullish (upward) or buying a Put if our Directional bias is Bearish (downward).

Not just any Call or Put will do.  We will run the available options through our gantlet of criteria, finding the best candidate for trading: Ideally, strike on the dollar, penny pricing, tight Bid/Ask spread.  Things really get fun when we find a deep Out-of-the-Money (OTM) option and watch it move In-the-Money (ITM).  That’s when we see returns in the thousands or tens of thousands of percent.  One payday like that can make up for many weeks of frustration!

Having a Directional bias can be as simple as knowing when a stock is overbought or oversold.  Here’s what I mean: When the price of corn is low, farmers don’t want to lose money, so they will stop planting it.  They’ll plant something else that will make them money.  Later on, when that harvest comes to market, there is less corn available.  Scarcity drives the price back up.  Then the cycle reverses.  Farmers plant a lot of corn, hoping to cash in on the boom.  The surplus drives the price back down again.

It doesn’t make sense to plant corn during a surplus.  Likewise, it doesn’t make sense to buy a Straddle when a stock is making an all-time low.  Stocks won’t go up forever and they won’t go down forever.  The market will regulate itself.  When a stock is making a high, there will be traders who say, “I believe that stock is getting too high, I should sell it.”  And when a stock is making a low, there are traders who will say, “I believe that stock is getting too low, I should buy it.”

Non-Directional Bias

More often than not, we don’t have a Directional bias.  But, honestly, we don’t need one.  We don’t care which way the stock is going to move, we just need to know that it’s going to move and have a general idea of when it’s going to move.  Knowing this, we can apply one of our Non-Directional strategies.

As with Directional strategies, there are a number of Non-Directional strategies also, some of them are quite complex.  We only rely on two simple ones: Straddles and Strangles.

A Straddle is a pair of options (a Call and a Put) with the same expiration date and the same strike price.  A Strangle is a pair of options with the same expiration, but different strike prices.

We use these as our Non-Directional trades because, with both a Call and a Put, it doesn’t matter which direction the stock moves, one of them is going to move In-the-Money (ITM).  The other one may subsequently expire worthless, or the stock may swing back enough to make it move ITM before expiration as well.

Even if one of our legs of the Straddle or Strangle expires worthless, as long as we have done our job well in selecting a good candidate, the other leg should make enough money to offset any loss we incur from the expired option.

Straddle and Strangle Math

Remember with Straddles and Strangles, there is no bias in direction.  We buy Straddles and Strangles when we expect greater volatility than the market has priced in.  We buy Straddles when the stock is at or near the strike price.  Since these options are At-the-Money (ATM), the time value is at its highest (time value is ALWAYS at its highest At-the-Money).  To offset this, we buy as close to expiration as we can, so there is little time value left.  The less time left, the less we pay.

Strangles are Non-Directional, just like Straddles.  And the same general setups used for a Straddle can be used for a Strangle.  There are just two major differences.  First Straddles MUST be placed when a stock is at or very near the strike price.  Strangles have more entry opportunities.

We can use a Strangle when the stock price is in between strike prices.  At that time both the Call and the Put used are the same distance away from the strike price.  In cases when there are lots of strike prices available when a stock is on a strike price, it may be between two other strike prices, so you could employ a Strangle even then.

While we use Strangles when we’re not set up for a Straddle, we also use them when there is more time before expiration.  The further away expiration is, the wider our Strangles can be.  But remember, Strangles can be too wide if there’s not enough time for the stock to move.

Straddles cost more, but they come with a guarantee.  With a Strangle, the possibility exists that both the Call and Put will expire worthless.  Since a Straddle’s Call and Put have the same strike price, that is not possible.  Either one of them will be ITM or both will be ATM at all times.  Because of this, Straddles have more consistent returns (another reason they cost more).

When a Strangle works, it produces better returns than a Straddle.  It just doesn’t work as often.  Straddles are more consistent, so they work better on smaller moves in the market.  If you use a Strangle on a smaller move, the likelihood of having both your positions expire worthless is much greater.

Generally, we do not buy Non-Directional trades in the middle of the day (an exception being just prior to a mid-day event such as an FOMC Meeting or Minutes), because they are priced for movement that we don’t get.  Most of the movement may have happened already, but the decay hasn’t.  We can either trade them at the open and catch all of that day’s price action, or we can trade them at the close and try to catch a gap at the next day’s open.

By playing Straddles and Strangles, we are actually beating the market at its own game!  The market has no memory in its option pricing.  In theory, stocks should only be able to move in one direction, the total price of the Call and Put premiums for the time period.

For example, if a stock is at $50 and the $50 Call and Put options are both priced at $2.50, option pricing theory says the stock should stay in range from $45 to $55.  That’s the math, without going into great detail.  By buying both the Call and the Put, we are hedging our trade and looking for a move below $45 or above $55.

If the $50 Call and Put are priced at 25 cents each, then the math is telling us the market is expecting a move no greater than 50 cents.  In other words, a low of $49.50 to a high of $50.50.  This becomes the basis for our Straddle strategy.

Where we really start to make some money is when the stock’s move is bigger than what the market anticipates.  By using a Straddle and/or Strangle, we don’t care which direction it moves, as long as it moves!  The losing side can never go below zero.  So if the winning side moves enough, we get an extra profit.

The reason we use both Straddles and Strangles for our Non-Directional trades is because we want to make it as easy to have a viable setup as we possibly can.