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Guts

 

Description         

 

The Guts is a simple adjustment to the Strangle, but this adjustment makes it more expensive. Instead of buying out-of-the-money options, we buy in-the-money calls and puts, which creates a higher cost basis.

 

As with the Strangle, the risk we run with a Guts is that the break evens can be pushed further apart than with a Straddle.

           

To even contemplate a Guts, the Straddle criteria must have been satisfied first. We buy higher strike puts and lower strike calls with the same expiration date so that we can profit from the stock soaring up or plummeting down. As with the Strangle, each leg of the trade has limited downside (i.e., the call or put premium) but uncapped upside.

 

Again the same challenges apply regarding Bid/Ask Spreads and the psychology of the actual trade. Remember that time decay hurts long options positions because options are like wasting assets. The closer we get to expiration, the less time value there is in the option.

 

Use the Straddle rules but then make an adjustment for the Guts:

         

1.    Instead of trading the ATM calls and puts, choose the next strike higher for the put and the next strike lower for the call.

         

2.    Now compare the break even scenarios for the Guts to the Straddle. Typically the Guts break evens will be slightly wider. The Guts isnít very attractive when compared to the Strangle, but you can always compare the two with the Straddle, using the Analyzer.

         

Market Opinion

 

Neutral. You expect increased volatility in either direction.

 

P/L

 

 

 

 

 

When To Use

 

This is a more expensive strategy than a long Strangle. If you use it, you are doing a neutral trade, when implied volatility is low, for income. You are expecting the stock to either drop or rise significantly.

 

Example

 

XXXX is trading at $25.37 on May 12, 2011.

Buy August 2011 $22.50 strike call for $4.20.

Buy August 2011 $27.50 strike put for $3.80.

 

Benefit

 

The benefit is that it enables you to profit from the volatility of a stock moving in either direction with unlimited profit if the stock moves and limited risk.

 

Risk vs. Reward

 

The risk is the net debit of the bought puts and calls minus the difference between the strikes. The reward is unlimited.

 

Net Upside

 

Potentially unlimited.

 

Net Downside

 

Net debt paid minus difference between strikes.

 

Break Even Point

 

Break even up: higher strike plus (net debit minus difference between strikes)

 

Break even down: lower strike minus (net debit minus difference between strikes)

 

Effect Of Volatility

 

Looking for high volatility.

 

Effect Of Time Decay

 

Negative. Time decay accelerates the fastest in the last month, so never keep the last month.

 

Alternatives Before Expiration

 

If you have one month left until expiration, sell the position.

 

If you have a profitable leg, you can exit and hope the stock retraces to the unprofitable side at a later date. Sell the calls and take the profit. Although the puts will have little value, you can hope that if the stock retraces it will increase the value of the puts, which you can then sell.

 

Alternatives After Expiration

 

Close the position. However, it is recommended to close one month before expiration.

 
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