Breaking down a low-risk/high-reward version of the long strangle
Volatility can be a serious headache for a stock trader. Fortunately, the beauty of options is that there are several strategies that allow traders to capitalize off wild price swings. The long guts strategy, or the in-the-money strangle, is one such strategy: it allows bullish or bearish speculators to maintain a directional bias and profit even if they're wrong. If you are bracing for a dramatic price swing, the long guts strategy may be for you.
A long guts bears a striking resemblance to a long strangle, and is used by traders who anticipate a big move in the underlying equity, regardless of direction. The difference between a classic long strangle and a long guts play is that a long strangle typically uses two out-of-the-money strikes, while the long guts play will use at least one in-the-money strike.
Typically, a bullish trader will dole 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 more expensive option dictates the directional bias of the trade.
Profit possibilities are similar to 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.
Let's bring back Stock XYZ once more, which is trading at $46. If a trader expects that XYZ will move higher in the near future but concedes that the stock may move lower, they could initiate a long guts play. Since they lean bullishly, the higher premium will go to the in-the-money call option, and they'll simultaneously buy a near-the-money put.
With this in mind, the trader purchases a 44-strike call, asked at $3, and a 47-strike put, asked at $0.35. This brings the net debit to $3.35 for the pair, or $335 total (x 100 shares). To become profitable, the underlying equity must move beyond breakeven for either the call (call strike plus net debit) or the put (put strike minus net debit). In this case, $47.35 and $43.65, respectively. With XYZ trading at $46 -- closer to breakeven on the call side -- the bullish bias of the long guts is even more evident.
However, even if the shares wind up stagnant, the trader's losses are capped, as one of the options will always be in the money. If XYZ finishes at $45, the trader will only lose the initial debit minus the difference between strike prices ($3.35 - [47- 44]), or just $0.35 a spread, or $35 total -- 10% of your initial outlay. That's compared to a possible 100% loss for a long call or put.
In conclusion, by employing the in-the-money strangle, smart traders can be right while being wrong, without placing a ton of capital at risk. Though a long guts play does cost more to initiate than a long strangle, the low-risk/high-reward yield makes it a worthy strategy.