Long Guts (Guts)
The strategy of Long Guts is a less commonly known but very effective option trading strategy applied when an investor feels that the underlying asset will take a very large move, but cannot decide whether it is up or down. It shares similarities with Long Strangle but differs in that it entails buying options that are in-the-money, thus increasing the chances of success at the cost of higher cost.
The Long Guts Setup
Suppose you own a stock that is trading at $100. To create a Long Guts position, you might:
- Buy an in-the-money call option with a strike price of $95 for $10.
- Buy an in-the-money put option with a strike price of $105 for $10.
The total investment (and maximum risk) for this position is $20 ($10 for the call + $10 for the put).
Who Should Consider It
This is a good Long Guts strategy for traders who anticipate great price volatility but are unknown to direction. Investors who want to take maximum advantage of large price moves brought about by expected market events such as earnings reports, regulatory changes, or economic data releases would prefer this strategy.
Strategy Explained
By buying both ITM call and ITM put, the trader is ready for a big movement in either way. The strategy eliminates the task of guessing right the direction for the price to move, instead providing a margin of safety while covering both positive and negative moving scenarios.
Breakeven Process
Long Guts Strategy has two break-even points;
- Upper Breakeven: It is the value of the call strike price+ total premium that was spent.
- Lower Breakeven: Strike price of the put - total premium spent.
In this example, the upper breakeven would have been $115 ($95 + $20), and the lower breakeven would have been $85 ($105 - $20).
Sweet Spot
The sweet spot for this strategy occurs when the stock price moves sufficiently above $115 or below $85. These scenarios will maximize the value of one of the options while the other loses value, ideally less quickly because it is in-the-money.
Max Profit Potential
The maximum profit potential for the Long Guts strategy is theoretically unlimited on the upside and quite significant on the downside, limited only by the stock hitting zero.
Max Loss
When the stock price lies between the two strike prices at expiry, then the loss is restricted to the sum of premiums paid, because the intrinsic value of options will offset some amount of premium.
Risk
The main risk is that the stock price will stay between the strike prices, close to where it was when the strategy was initiated, resulting in a complete loss of the premiums paid. High initial costs due to purchasing ITM options also add to the risk.
Time Decay
Theta, also known as time decay, affects the Long Guts adversely and is one important factor in any trade. If both options have intrinsic value from being in-the-money, that is a little better than with out-of-money options, where time value dissolves, these still decline the closer they come to expiration while needing substantial move early in cycle to win at all.
Implied volatility has a rather subtle impact on this strategy. Increasing volatility can drive up the prices of both options and might be beneficial to the position if it is adjusted in time before expiration. Decreasing volatility is harmful as well as lowers the price of options, which would hurt the position if the stock price doesn’t move too much.
Conclusion
The Long Guts strategy provides a strategic choice for traders who expect high volatility without clear directionality in the underlying asset. Although it carries higher initial costs because of the purchase of ITM options, it provides a wider safety net against losses in stagnant markets than similar strategies such as the Long Strangle. This approach is useful in volatile markets with uncertain outcomes.