The long guts is a neutral strategy in options trading that involve the simultaneous buying of an in-the-money call option and an in-the-money put option of the same underlying stock and expiration date.
|Long Guts Construction|
|Buy 1 ITM Call|
Buy 1 ITM Put
This is an unlimited profit, limited risk strategy that is taken when the options trader thinks that the underlying stock will experience significant volatility in the near term. The long guts is a debit spread as a net debit is taken to enter the trade.
Large gains for the long guts strategy is attained when the underlying stock price makes a very strong move either upwards or downwards at expiration. The move in the underlying stock price must be strong enough such that either the long call or the long put rise enough in value to offset the loss incurred by the other option expiring worthless.
The formula for calculating profit is given below:
Maximum loss for the long guts strategy occurs when the underlying stock price on expiration date is trading between the strike prices of the options bought. At this price, while both options expire in the money, they have lost all their time value. It is this loss in time value that is the cost of employing the long guts strategy.
The formula for calculating maximum loss is given below:
There are 2 break-even points for the long guts position. The breakeven points can be calculated using the following formulae.
Suppose XYZ stock is trading at $40 in June. An options trader executes a long guts strategy by buying a JUL 35 call for $600 and a JUL 45 put for $600. The net debit taken to enter the trade is $1200.
If XYZ stock rallies and is trading at $50 on expiration in July, the JUL 45 put will expire worthless but the JUL 35 call expires in the money and has an intrinsic value of $1500. Subtracting the initial debit of $1200, the options trader's profit comes to $300.
On the other hand, if on expiration in July, XYZ stock is still trading at $40, both the JUL 35 call and the JUL 45 put expire in the money with $500 in intrinsic value each. Selling these options will net the options trader $1000 and because an initial debit of $1200 was taken to enter the trade, the result is a net loss of $200.
For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.
However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).
The following strategies are similar to the long guts in that they are also high volatility strategies that have unlimited profit potential and limited risk.
The converse strategy to the long guts is the short guts. Short guts are used when little movement is expected of the underlying stock price.
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