Directional vs. Non-Directional Strategies

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.

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.

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.

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.

Pattern reorganization, trend following and moving average crossover-based strategies are a few examples of the most widely applied directional trading strategies. Common examples of nondirectional or neutral trading strategies include arbitrage, sector matching, stock matching, pair trading, risk reversal, straddle, strangle, guts and butterfly.