Execute A Long Guts – Profit From Increased Volatility

Introduction To Long Guts Option Strategy

Execute A Long guts

If trading conditions are expected to be volatile, the long guts strategy may be a strategy that traders would want to consider.It involves buying 1 in the money put option and 1 at the money call option with the same expiration date derived from the same underlying security. An attractive feature is that the loss related to a long guts is capped while profit is unlimited.

Long guts – Net debit

The long guts involves the buying of options.As a result, the trade is established on a net debit, meaning that it results in deduction in the trader’s account.

Steps

Step 1 : Perform economic, fundamental and technical analysis
Step 2 : Outlook – Anticipating High Volatility
Step 3 : Study the option chain
Step 4 : Breakeven Analysis
Step 5 : Limited Loss
Step 6 : Loss Calculation
Step 7 : Unlimited profit
Step 8 : Profit calculation
Step 9 : Calculate Risk & Reward Ratio
Step 10 : Set Up Trade :Executing a long guts options trading strategy
Step 11 : Exit Trade
Step 12 : Record Trade In Diary

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Step 1 : Perform economic, fundamental and technical analysis

It is important to have a general grasp of the economy and the fundamentals of the underlying security. Look ahead and anticipate events or announcements which will cause volatility levels to increase. Some suggested chart patterns to look out for are:

The idea is to execute the trade before breakout occurs.

Read : Basic Economic Analysis , Basic fundamental Analysis and  Introduction to technical analysis

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Step 2 :Outlook – Anticipating High Volatility

The long guts options trading strategy is a neutral options trading strategy with an anticipation towards increased volatility of the price of the underlying security. When that happens, the long guts strategy has a greater probability of earning a profit. Conversely, if there is little to no volatility in the price of the underlying security, there is a greater probability of making a maximum loss.

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Step 3 :Study the option chain

Examine the options chain. Determine the options (with different strike prices) which can be used to construct the long guts.

Read :  Learn to read and understand options chain

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Step 4 : Breakeven Analysis

Perform breakeven analysis and find out the zones of profitability for a long guts.

The downside breakeven point can be calculated as :

Exercise price of put  – net debit

The upside breakeven point can be calculated as:

Exercise price of call + net debit

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Step 5 : Limited Loss

Execute A Long guts

The long guts strategy is a limited loss strategy.

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Step 6 : Loss Calculation

The maximum loss of the long guts can be calculated as:

Net debit – (Exercise price of put – Exercise price of call)  + commissions paid to the broker

The maximum loss occurs when the price of the underlying security trades between the exercise(strike) price of the put and the exercise(strike) price of the call.

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Step 7 : Unlimited profit

The long guts options trading strategy is a designed to capture significant movements in price of an underlying security in either the up or the down direction. The larger the magnitude of the price move, the greater the profit. Hence, the profit potential of the long guts is unlimited, dependent on the magnitude of the price move.

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Step 8 : Profit calculation

A profit is attainable when the price of the underlying security is greater than the upper breakeven point or when the price of the underlying security is less than the lower breakeven point. At this point, a trader may have a target price. Work backwards and calculate the potential profit.

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Step 9 : Calculate Risk & Reward Ratio

With the estimated profit and maximum risk, one is able to calculate the risk reward ratio. This step should be done to ascertain that the potential reward is worth the risk.

Read more : Understanding Risk/Reward Ratio For Option Traders

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Step 10 : Set Up Trade :Executing a long guts options trading strategy

A trader who executes a long guts strategy will:

  • Buy 1 in the money put
  • Buy 1 in the money call

Both options will have the same expiration date and are derived from the same underlying security. The ratio of long in the money calls to puts is thus 1 : 1. A trader can buy 100 In the money puts and 100 in the money calls and the trade would still be considered a long guts trade.

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Step 11 : Exit Trade

Once a reasonable profit is realisable, one can exit the trade. Look for a minimum profit of 50%. A trader can also exit the trade if there is little chance  that there will be increased volatility due to changed circumstances and that time value erosion starts to erode at a rapid  rate.

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Step 12 : Record Trade In Diary

Record the trade in a diary and begin the analysis of the mistakes made in the trade and what could have been done better.

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Example

The price of OOO Corp is trading at $80. With 45 days left to expiration on July options, a trader decides to execute a long guts based on OOO by:

  • Buying a July 75 call @$6.50
  • Buying a July 85 put @$6.50

As a result, a net debit is deducted from the trader’s brokerage account. The net debit can be calculated as:

($6.50 + $6.50) x 100 = $1300

From here, you can see that it is quite expensive to get into a long guts trade. Therefore, a trader must anticipate a price move with a significant magnitude to earn money. For starters, the price of the underlying security must trade above the upper breakeven point or trade below the lower breakeven point to turn a profit.

When the price of OOO trades at $80 on expiration:

Beginning value Ending value Profit(+) or Loss(-)
Long July 75 call $6.50 $5 -$1.50
Long July 85 put $6.50 $5 -$1.50
Overall loss -$3

The total loss is thus :

$3 x 100 = $300

This loss is equal to the loss of time value even though the options expire in the money.

This is also the maximum loss. It can be calculated as:

($6.50 + $6.50 -( $85 – $75 ) ) x 100 = $300

If the price of OOO trades at $100 on expiration:

Beginning value Ending value Profit(+) or Loss(-)
Long July 75 call $6.50 $25 +$18.50
Long July 85 put $6.50 $0 -$6.50
Overall profit +$12

The total profit is thus :

$12 x 100 = $1200

If the price of OOO trades at $0 on expiration:

Beginning value Ending value Profit(+) or Loss(-)
Long July 75 call $6.50 $0 -$6.50
Long July 85 put $6.50 $85 +$78.50
Overall profit +$72

The total profit in this case is:

$72 x 100 = $7200

As you can see from the above 3 tables, you must be able to tell that the greater the magnitude of price movement, the greater the maximum profit earned from a long guts.

Straddle, Strip and Strap

An options trader that wants to study similar options trading strategies with very similar payoff profiles should also examine the straddle, the strip and the strap options strategies. All these strategies are similar in the sense that they have limited loss potential and unlimited potential profit with large swings in the price of the underlying security.

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