What is a Short Guts Strategy?
The short guts options strategy is one of many that might be suitable for you, and can be viewed as a type of short strangle. However, it is only possible in a few scenarios.
The short guts options strategy is range bound which means that it only produces a profit within a certain range of values, and should only be attempted if the market is displaying incredibly low volatility, or shows no indication of moving.
It requires the sale of an in-the-money call, and an in-the-money put at the same time. But, in order to understand the mechanism of the strategy more easily, let's look at an example of this.
A Short Guts Example
Short Guts Entering
In order to use the short guts strategy, we first need to identify the stock that we are going to trade. As mentioned above, these need to have very low volatility.
One way in which we can ensure that the stock is low volatility is to look at its historic movement. Another way is to make sure that there is no information coming out in the new future that may influence the value of the option or its underlying asset, for example quarterly earnings.
Let's say we identify stock X, currently trading at $100. It is a food and beverage company and no news on inflation rates of food will be released soon and there is no news expected internally either.
We sell an in-the-money call option for stock X, with a 30 day expiration and strike price of $110, and collect a premium of $5, which is a bearish trade.
We then sell an in-the-money put option, entering a bullish trade, with the same expiration date but a strike price of $90. Here we also collect a premium of $5.
We have now entered the short guts.
As long as the price does not move too much, staying between the strike prices of $90 and $100, both options will fall through and we will keep the premium of $10.
However, if the prices move too far in either direction you will lose a lot of money, as is illustrated by the graph below.
Short Guts Exiting
There are several ways that you can exit a short guts strategy.
Firstly, and that with the most risk, is you can wait for the expiration date of the options. This is the riskiest because there is still a chance for the situation to become unprofitable while you wait, however, it is also the most profitable as it cuts out additional fees which are associated with the second exit strategy.
The second way to exit the short guts strategy is simply to buy the options back when it seems as if they might become profitable. This may seriously minimize your profit, or even cause a small loss when you have to pay a premium of your own, but this does prevent the large losses that can be seen in the image above.
Short Guts Break Even
As can also be seen in the image above, there are two break even points. It is important to know these so that you know exactly where you will be making money and where you will be losing it, so that you can better evaluate the risk of the trade.
These break even points can be calculated using the following equation:
Upper break even = Total Premium + Short Call Strike
Lower break even = Short Put Strike - Total Premium
This does not, however, take into account any commissions or fees that you may pay, which should be carefully considered when entering any trade.
Advantages of Short Guts
It is sometimes difficult to profit when the volatility of stocks is low, especially when fees and commissions are included. The use of short guts ensures that you still have the opportunity to trade and reach your goals, even in conditions that would usually not be considered optimal for trading.
Additionally, the potential profit can be quite high because you are selling In-the-money options. This means that the premiums will be higher than they would be otherwise, allowing a high expected return.
Disadvantages of Short Guts
The nature of options can be thought of as all or nothing. This means that, even though there are potentially large rewards to be earned through the use of options you can also lose a lot and short guts is no different.
Because the price of the option and underlying asset can potentially increase or decrease an unlimited amount in either direction, there is unlimited risk.
Additionally, the use of the strategy rules out the possibility of unlimited reward. This means that the short guts strategy is higher risk than simply buying a single option.
The Opposite of Short Guts
The opposite of short guts is a strategy simply referred to as long guts. Instead of selling, one buys an in-the-money call option with a lower strike price and an in-the-money put option with a higher strike price.
In this case, the values between the strike prices will result in a maximum loss, while large quantities of movement will result in potentially endless profit. This is a good strategy if there is high volatility.
Is Short Guts for You?
The use of short guts is not for everyone. Whether or not this strategy is useful for you depends on the experience that you have with options specifically, as well as risk mitigation.
As part of a larger portfolio, a trade such as short guts, with unlimited risk, might not have as severe consequences. However, if you are dealing with a smaller portfolio then a single mistake might wipe out your entire trading account.
For this reason it is recommended that the short guts strategy be used with great caution.
However, if you have the funds, and the markets are displaying low volatility, preventing you from profiting through any other means, then the use of short guts could provide high returns, provided that you are sufficiently hedged against risk.
Remember, trading is risky, especially options trading, which tends to be all or nothing. It is important to manage your risk in order to ensure your success as a trader.
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