|Short Guts Construction|
|Sell 1 ITM Call|
Sell 1 ITM Put
This is a limited profit, unlimited risk options trading strategy that is taken when the options trader thinks that the underlying stock will experience little volatility in the near term. The short guts is a credit spread as a net credit is taken to enter the trade.
Maximum gain for the short guts strategy is limited and occurs when the underlying stock price on expiration date is trading between the strike prices of the options sold. 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 the short guts strategy aims to capture as profit.
The formula for calculating maximum profit is given below:
Large losses can be experienced when the underlying stock price makes a strong move either upwards or downwards at expiration.
The formula for calculating loss is given below:
There are 2 break-even points for the short 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 short guts strategy by selling a JUL 35 call for $600 and a JUL 45 put for $600. The net credit received when entering the trade is $1200.
If XYZ stock rallies and is trading at $50 on expiration in July, the short JUL 45 put will expire worthless but the short JUL 35 call expires in the money and has an intrinsic value of $1500. Buying back this short put to close the position requires $1500. Subtracting the initial credit of $1200, the options trader's loss comes to $300.
However, 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. As the options trader had received $1200 when entering the trade, and closing the position requires only $1000, a profit of $200 is made.
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 short guts in that they are also low volatility strategies that have limited profit potential and unlimited risk.
The converse strategy to the short guts is the long guts. Long guts are employed when large movement is expected of the underlying stock price.
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