A challenging question every trader comes across in his trading career is: whether he should be buying a call option or a put option? Traders establish directional bias by studying high-level charts, support and resistance levels, price action, and fundamental indicators. Dow Theory suggests that the market will continue to move in the same direction until an external force causes a reversal or break in the trend.
Directional bias plays a major role in the ‘trend-reversal’ strategy than in the ‘trend following’ strategy. Directional bias will help a trader decide if he should be going long or short in options. You can also identify the direction of the market trend. Once you establish a directional bias, you will have greater confidence in executing your trading strategy. During the process of execution, none of the actions are emotionally driven.
How to develop a directional bias?
Any trade which includes thorough preparation should consist of establishing directional bias, and it is a two-step process.
- Predicting the direction of the price move and overall trend.
- Identifying the trigger points and trading rules that will confirm our directional bias.
Determining a directional is just one step towards making a successful trade. There are many more things we need to put together before taking a trade. After backtesting a few strategies, establish some trading rules. Remember to include only those rules that confirm your directional bias. Confirming directional bias is an excellent habit that improves the success rate of trades.
A successful trading strategy is more about the right planning and psychology rather than a single entry technique or trading system. Options trading is said to be complex, hence requires a lot of knowledge before one can trade it. Other than that, you need to consider factors that are specific to options like time decay, option theta, option beta, and option gamma. We explain here how it is to be done correctly.
Directional bias through momentum indicators
The easiest way to establish directional bias is by using momentum indicators and price action analysis. If prices are trending in an upward direction, making higher highs and higher lows, traders should look to buy. On the other hand, if prices are making lower lows and lower highs, traders should look to sell. In this strategy, momentum indicators can be used as an additional confirmation tool.
Example of buying a call option
In the above picture, the orange line graph represents the momentum indicator. The price action pattern shows a formation of higher highs and higher lows, with the indicator pointing towards the buy-side. The candlestick pattern should be such that there is no opposing force that could possibly reverse the current trend.
Point of entry: The exact point of entry would be after the formation of at least one higher high and higher low. This is confirmed by the momentum indicator, which shows a sudden rise above the average value. This is a low-risk entry with maximum reward.
Take profit and stop loss: When the momentum indicator no longer makes higher highs and higher lows with the main trend, it is a sign that the trend might be coming to an end. Hence, you should book profits here. Stop-loss in this strategy should be placed below the previous higher low.
Note: All the trades discussed above are to be executed using a call option and not using the cash segment. It is advised to choose the strike prices accordingly. There could be some differences in the entry price and stop loss of options when compared to spot prices.
The same rules apply for sell trade as well, but here a put option needs to be bought, and you would essentially want to look for lower lows and lower highs.
Directional bias through Moving averages
We would like to conclude our methods of establishing directional bias with the use of ‘moving averages.’ This is one such technical indicator, which can be used to develop any new strategy. For this strategy, we use the 20-day moving average as it is considered to be one of the most powerful moving averages.
In the above figure, we have plotted the 20-day Moving average using the yellow line. This is a simpler strategy as compared to the momentum indicator strategy. Here, if you see the price trading above the 20-day MA, you should form a directional bias to buy. And if the price is trading below the 20-day MA, you should form a directional bias to sell.
Point of entry: When price crosses the MA line on any side and stays there for more than four candles, you should be taking entry in that direction of the trend. More the number of candles better will be the entry.
Take profit and stop loss: You can continue to hold on to the trade until the price reverses and crosses the other side of the MA line. If it crosses, book out your profits. Stop-loss can be placed at the high or low from where the market reverses.
If you use any other way of developing directional bias, make sure that it needs to be simple. If it becomes complicated, it can increase the complexity of your trading strategy. Having a directional bias will make you trade in the direction of the dominant trend, which is less risky. Finally, a trader needs to abstain from opening positions that have no directional bias.
We hope you find this article informative. If you have any questions regarding this strategy, please let us know in the comments below. Happy Trading!