Short Guts
This is one of the lesser used but fascinating options trading strategies which is utilized by an investor if he believes the underlying asset is going to show minimal movement in its price. It is more or less a reverse strategy from the Long Guts and the investor sells the in-the-money (ITM) options; both call and put. This configuration enables the trader to recover a higher initiating premium as compared with out-of-the-money strategies such as the Short Strangle, but at the same time has higher risk because of the in-the-money nature of the options sold.
The Short Gut Setup
Assume a stock is selling for $100. In setting up a Short Guts you might:
Sell an in-the-money call option at $95 for $10.
Sell an in-the-money put option with a strike price of $105 for $10.
The total initial credit received for this position is $20 ($10 from the call + $10 from the put).
Who Should Consider It
The Short Guts strategy is suited for investors that expect the underlying stock to stay relatively stable and close to the current price. It is quite attractive when the implied volatility is high, because premiums are richer, thus making the potential income from the trade higher.
Explaining the Strategy
The trader takes in a considerable premium upfront, as the options are ITM, and these have a greater intrinsic value compared to an out-of-the-money option. Hopes are high that the underlying asset’s price will remain within the strike prices, and, therefore, these two options may expire worthless with the premiums becoming complete profit to the trader.
Breakeven Points
Two breakeven points exist in the Short Guts strategy
- Upper Breakeven: Call strike price + total premium received.
- Lower Breakeven: Put strike price - total premium received.
In the above example, the upper breakeven will be $115 ($95 + $20) and lower breakeven will be $85 ($105 - $20).
Sweet Spot
For this strategy, the sweet spot happens at expiration, where the stock price ends up between the two strikes ($95 and $105 here). This way, the trader is left to maintain the full premium collected.
Maximum Profit Potential
Maximum profit is confined to the premium taken in the very beginning, which is $20 for this example.
The upside has no theoretical limits, and the downside is huge, as theoretically, the price of the stock can go on forever or hit zero.
Risk
This strategy has a lot of risk because it involves shorting ITM options. A major adverse move in the price of the underlying stock could result in huge losses if the stock moves significantly past either breakeven point.
Time Decay
Time decay (theta) is on the side of the Short Guts strategy. In case the underlying price remains stable till expiration date, it is seen that value of options decline thus helping the seller.
An increase in implied volatility is generally unfavorable for this strategy after the position has been established, as it can increase the value of the options sold, potentially causing losses. Conversely, a decrease in implied volatility is beneficial as it diminishes the options’ value, aiding the trader in potentially securing profits sooner.
Conclusion
The Short Guts strategy is aggressive trading, hence offering high potential income from premiums collected if the price of the underlying asset stabilizes. Its risks are tremendous, especially because of large movements in the underlying asset’s price. It suits experienced traders closely monitoring their positions and managing their risk well.