The Option Coach: Long Guts

              

Welcome back to another in a series of articles that examines the thought process behind a variety of option strategies using stock, index, and/or exchange-traded fund (ETF) options. This column will examine a long guts trade, the pros and cons of putting on this trade, and the profit and loss potential of this position. So, let's jump into this interesting strategy.

I have uncovered a strategy with an interesting name – long guts – that focuses on a pair of options that are in the money. This trading strategy is considered a debit spread since the trader pays a net debit when the position is initiated. But while a typical debit spread employs either two calls or two puts, the trader of a long guts position will buy one in-the-money call and one in-the-money put on the same underlying stock with the same expiration date.

The profit on the position is unlimited, since the stock's upside move is theoretically unlimited. This strategy is opened when a trader is expecting the shares of the underlying stock to experience significant volatility during the life of the options. A long guts position is similar to a strangle position, except that a strangle position uses two out-of-the-money strikes. In addition, a trader may chose to use a long guts over a strangle because of the smaller risk despite the larger initial debit.

Stock and Option Selection

A trader looking to use a long guts strategy should focus on options that match his expectations for the move in the shares. If the trader is looking for a short-term jump in the shares, he may want to consider front-month options. On the other hand, a longer-term move might require an option with several months until expiration.

Another thing to consider is that a trader may want to use options with low implied volatility at the time of purchase. An increase in implieds during an event or as an event approaches will help to increase the premium on the purchased options.

Let's Look at an Example

For a long guts spread, our trader has turned to Electronic Arts Inc. (ERTS: sentiment, chart, options) . The company is slated to report earnings on Nov. 9, with analysts anticipating a profit of 7 cents per share. This estimate is up sharply from the company's year-ago loss of 6 cents per share. Historically, the firm has put in a mixed performance, as it has surpassed the consensus estimate in two of the past four quarters.

Technically speaking, the equity has put in a respectable performance, gaining more than 11% since the beginning of the year. The security had recently pulled back to support in the 17.50-18 region – an area that has boosted the shares in the past. The stock could use this level to springboard higher on a positive earnings report, while a drop below this support level could mark the start of a sharp decline.

From a sentiment standpoint, investors are mixed in their stance toward the shares. The Schaeffer's put/call open interest ratio comes in at 0.50, as call open interest doubles put open interest among options slated to expire in less than three months. What's more, this ratio is lower than 79% of all those taken during the past year. In other word, short-term options players have been more optimistic toward the shares only 21% of the time during the past year.

What's more, the International Securities Exchange (ISE) has seen an increase in call trading. During the past 10 trading sessions, nearly 6.5 calls have been purchased to open for every one put purchased to open. This ratio of calls to puts is higher than 79% of all those taken during the past year.

On the other hand, Wall Street is split on the shares. According to Zacks, 10 of the 22 analysts following ERTS rate it a "buy" or better. Any upgrades or downgrades from this group could cause the shares to move sharply.

With ERTS currently trading at $17.82, the trader has decided to buy one contract of the November 16 call, which is asked at $2.15, and one contract of the November 20 put, which is asked at $2.45. The net debit for the position is $4.60 (2.15 + 2.45).

Implied Volatility

Rising volatility is a benefit to this position as it makes the options more expensive when they are sold to close. The trader is looking for the implied volatility of the options to increase so that the purchased options can be sold at a more expensive price.

Profit and Loss

The maximum gain is unlimited. The long gut spread has the potential for large gains, which are attained when the stock price makes a very strong move either higher or lower at expiration. The move in the underlying stock price must be strong enough such that either the long call or the long put rises enough in value to offset the initial debit. This strategy is similar to a strangle, which uses out-of-the-money calls and puts.

The maximum loss is calculated by subtracting the initial debit from the difference of the two strikes, which would be ([20 -16] – 4.60) $0.60 in this example. (Correction: An earlier version of this article miscalculated the maximum loss.)

There are two breakeven points for this position. The upper breakeven point is found by adding the net debit to the call strike. The upper breakeven point for the example would be 20.60 (16 + 4.60). The lower breakeven is found by subtracting the net debit from the put strike. The lower breakeven point for the example is $15.40 (20 – 4.60).

Overview

Overall, this is an expensive strategy because it involves the purchase of in-the-money options. As a result, the trader needs a large move to overcome the price of the position.

In case you've missed some of the other strategies covered in this column, here is a quick list of links to some of the other topics we have covered here.