The Option Coach: Short 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 short guts trade, the pros and cons of putting on a short guts strategy, 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 – short guts – that focuses on a pair of options that are in the money. This neutral trading strategy is considered a credit spread since the trader receives a net credit when the position is initiated. Yet, instead of the credit spread encompassing either two calls or two puts as usual, the trader of a short guts position will sell one in-the-money call and one in-the-money put with the same expiration date on the same underlying stock.

The profit on the position is limited, while the risk is unlimited since the stock's upside move is theoretically unlimited.

Another risk with this position is that the sold options could be exercised at any time due to the fact that both the options are in the money when they are purchased.

Stock and Option Selection

This strategy is opened when a trader is expecting the shares of the underlying stock to experience little volatility during the life of the options. A trader looking to use a short guts strategy should focus on short-term options, as this reduces the chance of the underlying shares experiencing a sharp jump in volatility that will make these options more expensive to repurchase. A trader will also want to make sure that the stock does not have a planned event such an earnings report prior to the expiration of the sold options

Another thing to consider is that a trader may want the use options that currently have high implied volatilities. An unwinding of these implieds will decrease the premium of the option, making them cheaper to repurchase should it become necessary.

Let's Look at an Example

For a short guts spread, our trader has turned to Intel Corp. (INTC: sentiment, chart, options). The security staged a nice rally from its March low of $12.05 The equity has gained more than 58% during that time frame, but has recently fallen into a sideways trading range. The equity has been trapped between resistance at the 20.50 level and support at the 18.50 level during the past couple of months and is showing signs of continuing this consolidation.

Meanwhile, sentiment is still mixed on the stock. The Schaeffer's put/call open interest ratio comes in at 0.58, which is in the middle of its annual range. However, call trading is on the rise. The International Securities Exchange (ISE) has seen 3.9 calls purchased to open for every one put purchased to open during the past 10 trading sessions. This ratio is higher than 87% of all those taken during the past year.

Wall Street continues to be a big supporter of the shares, as 24 of the 33 analysts following the security rate it a "buy" or better. Any downgrades from this group could add some selling pressure to the shares, keeping the equity locked in its sideways channel.

With INTC currently trading at $19.01, the trader has decided to sell one contract of the November 18 call, which is bid at $1.09, and one contract of the November 20 put, which is bid at $1.29. The net credit for the position is $2.38 (1.09 + 01.29).

Implied Volatility

Rising volatility is the enemy of this position as it makes the options more expensive to repurchase. The trader is looking for the implied volatility of the options to decrease so that the sold options can be repurchased at a cheaper price.

Profit and Loss

The maximum gain is limited and it is reached when the stock is trading directly between the two strikes of the sold options. At this price, while both options expire in the money, they have lost all their time value. It is this loss in time value that the short guts strategy aims to capture as profit. The maximum profit for this position is calculated by adding the net credit received to the strike price of the short put and subtracting the strike price of the short call. In this case, the maximum profit is: $4.38 (2.38 + 20 – 18).

The maximum loss is unlimited due to the fact that the stock is not limited in how far it can rise.

There are two breakeven points for this position. The upper breakeven point is found by adding the premium to the call strike. The upper breakeven point for the example would be 20.38 (18 + 2.38). The lower breakeven is found by subtracting the net credit from the put strike. The lower breakeven point for the example is $17.62 (20 – 2.38).

Overview

Overall, this is a risky strategy reserved for veteran options traders since there is limited reward and unlimited risk. In addition, the trader should keep in mind that there are four commissions if it is successful: two paid to get into the position and two paid to close out the trade.

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.