Using Call Spreads to Trade a Binary Directional Forecast

Summary

The document asks how to trade a model that predicts only whether a stock will rise or fall over a fixed interval, without estimating the move’s size. The response frames the decision around what probability the market has already priced in. If the market prices an equal chance of finishing above or below the current fair price, a directional forecast can be expressed using an options spread rather than a simple stock position.

For an upward signal, the example is a European call spread with strikes placed symmetrically around the fair price and expiration at the forecast horizon. With strikes sufficiently close to that price, the spread approximates a bet on whether the stock finishes above the threshold; a corresponding put spread could express a downward view. This is a conceptual suggestion, not a tested strategy. Its usefulness depends on market-implied probabilities, option pricing, and transaction costs, none of which are evaluated in the document.

Key ideas

• A binary direction forecast does not specify the size of the expected price move.
• The value of a directional signal depends on the probability already reflected in market prices.
• A call spread around the fair price can approximate an upward bet on the terminal price crossing that level.
• A spread’s payoff depends on expiration price and option pricing, so the example is not evidence of a profitable strategy.

Tags

# Trading strategy using only binary forecast of price increase or decrease?


# Trading strategy using only binary forecast of price increase or decrease?












Take a hypothetical model that takes a stock as input and outputs "up" or "down" indicating if the stock price will increase or decrease in a fixed time interval T.

Assuming the model is correct >50% of the time, what are the strategies to trade given this information? No indication of how much the stock increases/decreases so a simple buy strategy would obviously fail.

## Answer by justtryingtolearn (score 0)

https://quant.stackexchange.com/a/78047

I believe it matters what probabilities are priced into the market. Assuming the market prices a 50/50 percent of up/down at time T, then you could trade a call or put spread to bet on the probability of stock going up or down.

If the stock is fair at 100, and the model says it will go up you could buy a European 100-d/100+d call spread expiring at time T. If d is small enough, this is essentially a bet on probability of stock being above or below 100 at time T.

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.