Short Gut Trading Strategy

When to Use a Short Gut

The short gut is designed to be used when your outlook on a security is relatively neutral, but you want to allow for a bit of movement in either direction. The potential losses are unlimited if the security moves substantially in either direction, so you need to be confident that such a move is unlikely before using this strategy.

A credit spread is created but margin is also required, so you will need to have enough investment capital. You'll also need to have a high trading level with your broker.

How to Implement a Short Gut

To implement a short gut you must place two sell to open orders simultaneously with your broker. You need to write in the money call options based on the relevant security, and write an equal number of in the money calls. The expiration date of the contracts should be the same, and they can be as long term or as near term as you want.

A short term expiration date means less time for the underlying security to move in price, but short term options have less extrinsic value. Profits are made from the extrinsic value of the options diminishing, so less extrinsic value will mean less potential profit. Longer term contracts will offer more in the way of potential profit, but they require more time for the price of the security to move enough to create a loss.

The other decision you need to make is how far in the money the contracts you write are. The calls and put should be in the money by an equal amount (i.e. the strikes should be equidistant from the current trading price of the trading stock), but you need to determine how far away from the current trading price you want the strikes to be.

The further in the money the options, the greater the price range that you'll profit from. However, extrinsic value decreases as options move further in the money, so your potential profit will be lower. Your decision ultimately comes down to whether you want to increase your chances of making a profit, or increase the size of the potential profit.

Below is an example of how you could apply this spread. Please note that we have not included commission costs, and have used hypothetical prices rather than real market data.

• Company X stock is trading at $50, and your expectation is that the price will remain relatively close to $50.
• In the money call options (strike $45) are trading at $6. You write 1 contract containing 100 of these options for a credit of $600. This is Leg A.
• In the money put options (strike $55) are trading at $6. You also write 1 contract containing 100 of these options, for a further credit of $600. This is Leg B.
• You have now created a short gut, for a total upfront credit of $1,200.

Profit & Loss Potential

The spread will return a net profit providing the price of the underlying security remains between the strikes of Leg A and Leg B. Therefore, in the case of this example you would need the price of Company X stock to be somewhere between $45 and $55. You will make roughly the same amount regardless of exactly where it is, but this amount is the maximum that you can make.

When the price of the underlying security does remain in the defined price range, you will have a liability on both the legs, but this liability will be limited. The higher the price of the underlying security, the higher the liability will be on Leg A, but the lower the liability will be on Leg B.

Conversely, the lower the price of the underlying security, the lower the liability will be on Leg A, but the higher the liability will be on Leg B. This might sound confusing, so let’s look at some scenarios to see how this works in practice.

• If the price of Company X stock remained exactly at $50 by expiration, the options in Leg A would be worth around $5 each ($500 liability), and the ones in Leg B would be also be worth around $5 each ($500 liability). The total liability is $1,000, which is deducted from your initial credit of $1,200 to give you a net profit of $200.
• If the price of Company X stock went up to $53 by expiration, the options in Leg A would be worth around $8 each ($800 liability), and the ones in Leg B would be worth around $2 each ($200 liability). The total liability is again $1,000 so your net profit is also $200.
• If the price of Company X stock went down to $46 by expiration, the options in Leg A would be worth around $1 each ($100 liability), and the ones in Leg B would be worth around $9 each ($900 liability). Once again, the total liability is $1,000 for a net profit of $200.

As you can see, regardless of exactly where the price of Company X stock ends up (providing it's within the defined range), you have the same liabilities and make the same amount of profit. The profit you make is basically the amount of extrinsic value that the options had at the time you wrote them, which has then eroded by the time of expiration.

This strategy can also make a profit if the underlying security moves ever so slightly outside the defined range, but the profits reduce the further outside the range it gets. If it goes far enough outside the range, then the spread will start to return a loss and the potential losses are unlimited. Below we have summarized the calculations for the profits, losses, and break-even points of the short gut spread.

• Maximum profit is made when “Price of Underlying Stock = or > Strike in Leg A and = or < Strike in Leg B”
• Maximum profit, per option written in each leg is, “(Price of Options in Leg A + Price of Options in Leg B) - (Strike of Leg A – Strike of Leg B)
• The short gut has two break-even points (Upper Break- Even point and Lower Break-Even Point)
• Upper Break-Even Point = “Strike of Leg A + (Price of Options in Leg A + Price of Options in Leg B)”
• Lower Break-Even Point = “Strike of Leg B – (Price of Options in Leg A + Price of Options in Leg B)
• The short gut will return a profit if “Price of Underlying Security < Upper Break-Even Point and > Lower Break-Even Point”
• The short s gut will result in a loss if “Price of Underlying Security > Upper Break-Even Point or < Lower Break-Even Point”

You can buy back the options written at any point prior to expiration if you wish to close your position. You can do this for a profit if the overall value of the options has dropped enough to return a profit, or to prevent losses if the security looks like moving outside of the break-even points.

Summary

The short gut spread can return a profit from a wide price-range, but the potential returns are lower than some similar strategies. The maximum profit is limited, but the losses are unlimited so there's a great deal of risk in applying this strategy.

You should only use this spread when you believe there's very little chance of the underlying security increasing above the strike of the puts you write or falling below the strike of the calls you write.