Long Gut Strategy

When to Use a Long Gut

The long gut is a strategy for a volatile market, and is designed to profit when you are expecting a security to experience a high level of volatility. It's a good strategy to use when you are confident that the price of a security will make a big move, but you aren't entirely sure which direction it will move in.

Despite the high upfront costs of this debit spread, the risk is considered quite low. Coupled with the fact that it's very straightforward, this makes the long gut suitable for beginner traders.

How to Establish a Long Gut

As we have already mentioned, the long gut is very straightforward. All you need to do is buy in the money call options and buy an equal amount of in the money put options, all based on the relevant security and with the same expiration date. The only two decisions you need to make are which strikes to use and which expiration date.

The calls and the puts should be an equal amount in the money (i.e. their strikes should be equidistant from the current trading price of the underlying security). In our opinion, you should use strikes that are relatively close to the current trading price of the underlying security so that you keep the upfront cost lower.

The expiration date you choose to use will also affect the upfront cost. If you choose a close expiration date, then the cost will be cheaper due to the reduced time value. However, the flipside to this is that there won't be as much time for the price of the underlying security to move enough to return a profit to you.

If you are confident that the price of the underlying security will move quickly then a short term expiration date is probably best. If you want to allow more time for the price to move, then a longer term expiration date is a better choice.

Below is an example of a long gut can be used. To keep things simple we have used hypothetical prices and not included commission costs.

• Company X stock is trading at $50, and you expect the price to move significantly, but are not sure in which direction it will move.
• In the money calls (strike $49) are trading at $2.50. You buy 1 contract of these (containing 100 options), at a cost of $250. This is Leg A.
• In the money puts (strike $51) are trading at $2.50. You buy 1 contract of these, at a further cost of $250. This is Leg B.
• You have now created a long gut for a net debit of $500.

Profit & Loss Potential

You can make potentially unlimited profits from this strategy if the underlying security moves significantly in price. A sizable price move, in either direction, will result in one leg returning a decent profit while you will only lose the amount invested in the other leg. The strategy will return a loss if the price of the underlying security only moves slightly or stays the same, but it will return an overall profit whenever the profit of one leg is greater than the loss of the other leg.

To help you understand the long gut fully, we have provided some illustrations below of what might happen when applying it shown in the example above. We have also shown the formulas that you can apply to calculate the potential profits, losses, and break-even points.

• If the price of Company X stock is $50 at the time of expiration, then the options in both legs will expire in the money. Each call and each put will be worth around $1 for a total of $200. Taking into account your initial $500 investment, you will lose a total of $300.
• If the price of Company X stock rises to $53 by the time of expiration, then the calls in Leg A will be worth $4 each ($400 total), while the puts in Leg B will expire worthless. The $400 value of the calls will partially offset the $500 initial cost and you will lose a total of $100.
• If the price of Company X stock rises to $57 by the time of expiration, then the calls in Leg A will be worth $8 each ($800 total) while the puts in Leg B will expire worthless. The $800 value of the calls will cover the $500 initial investment and will return a $300 profit overall.
• If the price of Company X stock is at $47 by the time of expiration, then the calls in Leg A will expire worthless and the puts in Leg B will be worth $4 each ($400 total). The $400 value of the puts will partially offset the $500 initial cost and you will lose a total of $100.
• If the price of Company X stock is at $43 by the time of expiration, then the calls in Leg A will expire worthless while the puts in Leg B will be around $8 each ($800 total). The $800 value of the puts will cover the $500 initial cost and return a $300 profit overall.
• Maximum profit is unlimited
• Profit is made when “Price of Underlying Security > (Strike of Leg A + Price of Each Option in Leg A + Price of Each Option in Leg B)” or when “Price of Underlying Security < (Strike of Leg B – (Price of Each Option in Leg A + Price of Each Option in Leg B))”
• The long gut has an upper break-even point and a lower break-even point.
• Upper Break-Even Point = “Strike of Leg A + Price of Each Option in Leg A + Price of Each Option in Leg B)”
• Lower Break-Even Point = “Strike of Leg B – (Price of Each Option in Leg A + Price of Option in Leg B)”
• The long gut will result in a loss if “Price of Underlying Security < Upper Break-Even Point and > Lower Break-Even Point”
• Maximum loss is limited to “(Price of Each Option in Leg A + Price of Each Option in Leg B) – (Strike of Leg B – Strike of Leg A)

If at any point before the options expire you feel the price of the underlying security isn't going to move sufficiently to return a profit you may want to consider closing your position to recover any remaining time value and minimize your losses. To do this, you simply sell the options that you own.

You may also want to do this if the strategy is in profit and you want to realize the profits early.

Long Straddle and Long Strangle

There are two alternative strategies to the long gut that are very similar and you may want to consider these as alternatives. The long straddle is cheaper to establish than the long gut, because you buy at the money options instead of in the money options. You can read more about this strategy here.

The long strangle is cheaper still, because you buy out of the money options. For more details on this strategy, please click here.

Summary

The long gut is a useful and simple strategy that can be used to try and make a profit when you have a volatile outlook. As there are only the two transactions involved, the commissions are relatively low and the strategy is fairly simply to use. There are no margin requirements, and only a low trading level is required.

Taking all of this into account, this is a good options trading strategy for beginners.