This Low-Risk Options Strategy Lets You Profit If You're Wrong

Long guts is a low-risk, high-reward options strategy for traders who want to take advantage of a stock's volatility

Dec 2, 2016 at 1:44 PM
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    There are several options strategies that allow traders to use market volatility to their advantage, and even more ways for speculators to make pure directional plays. The long guts strategy, or in-the-money strangle, offers the best of both worlds: it allows bullish or bearish speculators to maintain a directional bias and even profit if they're wrong.

    Like a classic long strangle, a long guts play is used by traders who anticipate a big move in the underlying equity, but the guts can be skewed bearishly or bullishly. The difference between a classic long strangle and a long guts play lies in the strike prices of the options at initiation. While a long strangle typically uses two out-of-the-money strikes -- such as a 97-strike put and a 103-strike call on an equity trading at $100 -- the long guts play will use at least one in-the-money strike. Typically, a bullish trader will shell out more money for an in-the-money call, while a bearish trader will pay more for an in-the-money put. Traders who prefer to be more directionally neutral can purchase an in-the-money call as well as an in-the-money put, though the option with the highest premium still lends its directional bias to the trade.

    Profit from a move higher is theoretically unlimited, while profit from a downward move is capped, since a security can't fall lower than $0. This is similar to profit possibilities from purchasing a straight call or put, though unlike "vanilla" option buyers, the long guts trader stands to still make money if their initial bearish or bullish bias doesn't pan out. On the flip side, the maximum risk with a long guts position is limited to the net debit minus the difference between the strikes -- making for an enticing risk/reward scenario.

    Take stock XYZ, for example, which we'll say is trading at $99. If a trader expects that XYZ will move higher in the near future -- say, after earnings next month -- but also thinks there's a small possibility the stock may move downward, she may initiate a long guts play. Since the trader leans bullishly, she'll pay a slightly higher premium on her in-the-money call option, while still purchasing a near-the-money put.

    With this in mind, the trader decides to purchase a 97-strike call, asked at $2.50, and a 100-strike put for $1.50. This brings the net debit to $4.00 for the pair, or $400 total (x 100 shares). For this play to become profitable, the underlying equity must move beyond breakeven for either the call (strike plus net debit) or the put (strike minus net debit) -- $101.00 and $96.00, respectively. In this instance, the intrinsic value of the in-the-money option will offset the losses incurred from the out-of-the-money option, resulting in a net gain. It's obvious that the call's breakeven is closer to XYZ's current price, further echoing the bullish tilt.

    However, even if the shares wind up between the breakeven rails, the trader's losses are limited, as one of the options will always be in the money. For example, if XYZ finishes at $98, the trader will only lose the initial debit minus the difference between strike prices ($4.00 - [100 - 97]), or just $1.00 a spread, or $100 total -- 25% of your initial outlay. That's compared to a potential 100% loss of premium paid for a long call or put, or even a simple strangle.

    In conclusion, by employing the in-the-money strangle, smart traders can make a pretty penny without placing a ton of capital at risk -- and even profit if their initial forecast for the stock doesn't come to fruition. Though a long guts play will cost more to initiate than a simple call or put purchase, or even a long strangle strategy, the low-risk/high-reward backdrop makes it attractive. 

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