Long Guts (Guts)

The Long Guts strategy is a lesser-known but effective option trading tactic used when an investor expects significant movement in the underlying asset but is uncertain about the direction of the move. It's similar to the Long Strangle, but involves purchasing in-the-money (ITM) options, increasing the probability of a profitable outcome at the expense of higher initial cost.

The Setup

Consider a stock trading at $100. To establish 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

The Long Guts strategy is suitable for traders who expect significant price volatility but are uncertain of the direction. It’s ideal for investors who are looking to capitalize on large price moves resulting from anticipated market events like earnings reports, regulatory changes, or economic data releases.

Strategy Explained

By purchasing both an ITM call and an ITM put, the trader is positioned to profit from large moves in either direction. The strategy removes the necessity of correctly predicting the direction of the price move, providing a safety net by covering both upward and downward scenarios.

Breakeven Process

There are two breakeven points for the Long Guts strategy:

Upper Breakeven: Strike price of the call + total premium spent.
Lower Breakeven: Strike price of the put - total premium spent.

In this example, the upper breakeven would be $115 ($95 + $20) and the lower breakeven would be $85 ($105 - $20).

Sweet Spot

The sweet spot for this strategy occurs when the stock price moves significantly above $115 or below $85. These scenarios will maximize the value of one of the options, while the other loses value, ideally less rapidly due to being in-the-money.

Max Profit Potential

The maximum profit potential for the Long Guts strategy is theoretically unlimited on the upside and substantial on the downside, limited only by the stock reaching zero.

Max Loss

The maximum loss is limited to the total premiums paid if the stock price is between the strike prices at expiration, as the intrinsic value of the options partially offsets the premiums paid.

Risk

The primary risk involves the stock price remaining between the strike prices, close to where it was when the strategy was initiated, leading to a total loss of the premiums paid. High initial costs due to purchasing ITM options also add to the risk.

Time Decay

Time decay (theta) is a critical factor for the Long Guts as it negatively impacts the trade. Since both options are in the money, they will retain their intrinsic value better than out-of-the-money options would; however, their time value still decays as expiration approaches, requiring significant moves early in the trade cycle to be profitable.

Implied Volatility

Implied volatility has a nuanced effect on this strategy. An increase in volatility may increase the prices of both options, potentially benefiting the position if adjustments are made before expiration. Conversely, decreasing volatility can harm the position by reducing the price of the options, especially harmful if the stock price does not move significantly.

Conclusion

The Long Guts strategy offers a strategic option for traders expecting significant volatility without clear directionality in the underlying asset. While it involves higher initial costs due to the purchase of ITM options, it provides a broader safety net against losses in stagnant markets compared to similar strategies like the Long Strangle. This approach is particularly useful in volatile markets with uncertain outcomes.