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The Gut Strangle Strategy


The graphically named “gut strangle” is a seldom-used strategy, but it might work in some circumstances. This involves trading in-the-money calls and puts. A long gut strangle is set up by buying both options; and a short gut strangle calls for selling both sides.

This approach will work if you believe that profits will accumulate when you work with in-the-money positions rather than at- or out-of-the-money ones. For most traders, this long shot keeps them away from the “guts” and sets up a preference for the less expensive long or less risky short forms of strangles.

These can be opened in either configuration whether you own stock or just want to work with options.
 

Gut strangle (long)


image.png


A long gut strangle is the purchase of an ITM call and an ITM put. The idea is that either side needs to move enough points to exceed the cost of the options.


It is typically opened when you expect a big move but you’re not certain of the direction. For example, a stock tending to move a lot after earnings surprises may jump higher or fall lower, and a surprise is expected. The long gut strangle is a gamble because you will need many points of movement, but it also can pay off in a big way if the move takes place.
 

This sets up unlimited profit potential along with limited risk. A profit occurs when price moves more than the total cost to open the position:

 

            Underlying < long put strike – net premium paid

            Underlying > long call strike – net premium paid

 

The gut strangle will break even in two circumstances:

            Net premium paid + long call strike

            Strike of long put – net premium paid

 

The risk in the long gut spread is limited. It occurs when the underlying price ends up in between the two strikes:

            Net premium paid + strike of long put – strike of long call
 

Gut strangle (short)


image.png
 

A short position is set up by selling a call and a put, both in the money.


This version establishes limited profit with unlimited risk. It is the opposite of the long guts because both profit and loss are flipped.


With the sale, you receive the net premium for the two in-the-money options. This is the appeal of the short gut strangle. However, you also have to ensure that collateral is posted in your margin account for both options. Depending on the strike, this could be an inhibiting number.


The short gut strangle is an oddity. The short put has the same market risk as a covered call, but the short call is a high-risk position. It combines low-risk and high-risk in a single strategy.


The limited profit is equal to the net premium received, and it occurs when the underlying ends up in between the two strikes:

            Net premium received + short put strike – short  call strike


Breakeven occurs in two positions:

            Net premium received + strike of short call

            Strike of short put – net premium received


Maximum risk can be substantial and is unlimited. It occurs whenever the underlying moves above or below the strikes and exceeds premium received:

            Price of underlying < strike of short put – net premium received

            Price of underlying > strike of short call + net premium received


This can be modified away from the strangle and set up as a straddle, but more important than this is the analysis of potential profit or loss overall. The gut strangle is rarely employed because profits are difficult to earn and risks are difficult to overcome. Even so, it deserves consideration in the range of possible options strategies you could deploy.

Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his website at Thomsett Guide as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.

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They are less risky because the options have intrinsic value, therefore the negative theta of the long gut strangle is lower than in long OTM strangle, as percentage of the spread value.

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Combined intrinsic value is 0 (call is long, put is short, total = zero). Let say we have stock XYZ=100 and we buy call(80) and put(120), do you want to say that its different from call(120) and put(80)? 

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When you buy a gut strangle, you are long both calls and puts. So intrinsic value is not zero. 

Lets take an example, using AAPL as underlying.

With AAPL around $215, this is a strangle P/L chart (buy 230 call, buy 200 put):
 

image.png

And this is a gut strangle P/L chart (buy 200 call, buy 230 put):

image.png

As you can see, in in strangle case your maximum loss is 100%, but in gut strangle it is only 17%. Of course the gain for gut strangle is also much lower in percentage terms. So yes, in dollar terms, the charts are very similar, but in percentage terms, gut strangle is lower risk lower reward trade.

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An intrinsic value of call is neutralized by intrinsic value of put. Let take your AAPL example: 

Prices: 200 call = 19.25, 230 put = 16.85; 230 call = 2.77, 200 put = 3.15. When you buy ITM position you have to spend: 19.25 + 16.85 = 36.1, when you buy OTM, the cost is 5.92. BUT, why you just cannot reserve 3601$ on your account and buy OTM for 592$ - in that case, your graphs will be identical to ITM. As you mentioned - the risk in dollars are equal, but in case of ITM you block 3601$ - 592$ = $3009$ by your own instead of investing it into "risk-free" things at least (treasuries, etc). Plus bid/ask spreads for ITM are usually worse than OTM.

If your broker's tools are smart enough they calculate the required margin as for OTM and will not block $3K, but why we need to introduce redundant difficulties. 

For me, this strategy is meaningless, if you want to buy strangle - buy strangle and use remaining money as you want.

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Intrinsic values of call and put are both positive. How can they be neutralized one by another??

There are many strategies that are synthetically identical. Like buying long call and short put instead of buying the stock. Yet most people still buy the stock, while they can get the same P/L chart and more flexibility by buying "synthetic" stock (long call, short put).

If the strategy is meaningless for you, don't use it. What's the problem?

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How they can be neutralized? Very easy: let back to AAPL $216.02,  call 200, put 230. Call 200 has 16.02 of intrinsic value, put 230 has 13.98. Let say that cost of AAPL becomes $226.02, so intrinsic value of call is 26.02, intrinsic value of put is 3.98. So, in total is always 30, grow of intrinsic call leads to decrease of put and vice verse.

The problem is that strategy doesn't have any gains vs OTM, but just blocking more money from the account. It's strange to see it here, in one of the previous posts you mentioned (and it was fully correct) that buying ITM structures when it can be replaced with OTM - its a sign of bad options understanding.

You know, the synthetic stock is another story, it has different lifetime from stock and potentially different commissions (or/and margin)

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Once you are "spreading" there are no longer calls and puts...there are only "strikes".

For example, If a stock was $250 and I was bullish, and wanted to do a vertical of a $245 and $260 "strike" because as stock price rises, IV goes down, and it goes down the most on the upside "strikes"....the lower "strikes", as stock price moves higher, become more out of the money, and because of the natural "skew" in stocks, which skews up on the downside strikes, the $245 strike would become more OTM as stock price rises, and have less "extrinsic" value, plus IV would "skew up" as it becomes further to the downside.

 

Anyway, back to the original position.

Stock is at $250.

If you were bullish, and trying to establish the best long vertical position....There is absolutely no difference between being long the $245 "strike", and short the $260 "strike.

Whether you use calls or puts, it is the exact same position, with the exact same p/l, and identical exposure to the "greeks".

Because , whether you use calls or puts in this vertical, you are long the exact same amount of "extrinsic" value of each "strike, and have the same "delta",and it will perform exactly the same.

 

So, it is exactly the same with this "gut" position.

It does not matter whether you are using calls or puts .....if the stock is at $250, and you are long the $240 and $260 "strike", it does not matter whether they are calls or puts...it is the exact same position.

One example of when it is different is when a "spread" is not involved.

For example, the stock is $250, and you just want to be long the stock but don't want to have to lay out the cash to buy the actual stock.

If you just bought an .80 delta call outright, for example you would be laying out a small fraction of the cost of buying the stock, and if it is an .80 delta, that means that you only have exposure of 20% of the "greeks" because the call is 80% "intrinsic".

 

But, once a spread is involved, there is no difference between calls and puts.

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1 hour ago, vasis said:

How they can be neutralized? Very easy: let back to AAPL $216.02,  call 200, put 230. Call 200 has 16.02 of intrinsic value, put 230 has 13.98. Let say that cost of AAPL becomes $226.02, so intrinsic value of call is 26.02, intrinsic value of put is 3.98. So, in total is always 30, grow of intrinsic call leads to decrease of put and vice verse.

The problem is that strategy doesn't have any gains vs OTM, but just blocking more money from the account. It's strange to see it here, in one of the previous posts you mentioned (and it was fully correct) that buying ITM structures when it can be replaced with OTM - its a sign of bad options understanding.

You know, the synthetic stock is another story, it has different lifetime from stock and potentially different commissions (or/and margin)

Am with You, profiles all along the life are quite similar, so you gain or loose the same absolute dollars, but with the gut you are blocked much more money, cause both are ITM. Wrap up you gain/loose the same absolute money but you pay more with the gut one to to the same (I believe).

 

I hardly see the reasoning behind this strategy, unless the illusion that if you loose your perceive that percentage wise is less.

Edited by Javier

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I was a member, and traded on the floors, of various commodity exchanges throughout the 1980's and 90's.

The margin rules are very different for commodities futures and options than for equities and options.

Plus, as a "member" of an exchange the margin rules were almost non existent by comparison.

Anyway, there was a period of time when I represented a large firm in the gold pit.

They wanted to bring a LOT of cash into their accounts for whatever reason.

It didn't make any sense to me at the time, and I never would have done this for myself but, they wanted me to sell deep, deep, ITM strangles, like what is being discussed here.

 

It would make no sense in equities, and really makes no sense for a retail trader in equity options as well.

But, this was a "clearing member" of the exchange (Comex) that I was working for, so their reasons were very different , and by doing this it brought enormous amounts of cash into their "house accounts"..

But this was an entirely different situation, with different clearing member margin rules. So I guess it made some sense for them at the time.

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58 minutes ago, cuegis said:

I was a member, and traded on the floors, of various commodity exchanges throughout the 1980's and 90's.

The margin rules are very different for commodities futures and options than for equities and options.

Plus, as a "member" of an exchange the margin rules were almost non existent by comparison.

Anyway, there was a period of time when I represented a large firm in the gold pit.

They wanted to bring a LOT of cash into their accounts for whatever reason.

It didn't make any sense to me at the time, and I never would have done this for myself but, they wanted me to sell deep, deep, ITM strangles, like what is being discussed here.

 

It would make no sense in equities, and really makes no sense for a retail trader in equity options as well.

But, this was a "clearing member" of the exchange (Comex) that I was working for, so their reasons were very different , and by doing this it brought enormous amounts of cash into their "house accounts"..

But this was an entirely different situation, with different clearing member margin rules. So I guess it made some sense for them at the time.

Interesting info, thanks

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Kim, to clarify my position: I don't want to criticize the articles just to show my "awareness" in options. For instance, last topics from Ken Reel about "holding the strike" for calendars and naked puts are very smart and contr-intuitive (need to say him many thanks :) ).

But what described here may confuse beginners in the options and cast doubts on other stuff. 

 

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9 hours ago, vasis said:

Combined intrinsic value is 0 (call is long, put is short, total = zero). 

This is not correct. The combined intrinsic value is NOT zero.

5 hours ago, vasis said:

An intrinsic value of call is neutralized by intrinsic value of put. Let take your AAPL example: 

This is correct. The total intrinsic value remains the same when the stock moves (or increases if the stock passes one of the strikes).

Your point is to show that the equivalent position can be constructed with same strikes using OTM options, with less capital. We are in a full agreement here. However, the fact still remains that percentage wise, the ITM strangle is less risky. Yes, if you reduce your cash, you don't have to use it - but sometimes it is not easy psychologically, especially for less experienced traders. In fact, you can have the same argument regarding straddles and OTM strangles - why use straddles if you can do similar risk profile, with OTM strangle, using less capital?

The purpose of the article was to describe the strategy and let the readers to decide if it's worth consideration. I'm glad that it invoked a good discussion. 

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This discussion is interesting and many comments reveal a depth of knowledge. However, as I have observed over many years, some strategies are intriguing and present novel ideas for how trades could be executed. This does not mean it always (or ever) makes sense. The gut strangle, whether long or short, can be utilized in many situations. For example, in opening an installment purchase, a long guts would protect you in both directions; and although it would be expensive, it could be paid for in installments of short options expiring in one week, opened each week until the long LEAPS gut is paid for. Another case would apply for the risk hedge; LEAPS guts opened and paid for with short-term shorts. This is only one example and the more popular OTM positions could make sense. But the gut strangle presents possibilities that many traders will find attractive. I can see these being useful for several hedging possibilities.

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2 hours ago, Michael C. Thomsett said:

This discussion is interesting and many comments reveal a depth of knowledge. However, as I have observed over many years, some strategies are intriguing and present novel ideas for how trades could be executed. This does not mean it always (or ever) makes sense. The gut strangle, whether long or short, can be utilized in many situations. For example, in opening an installment purchase, a long guts would protect you in both directions; and although it would be expensive, it could be paid for in installments of short options expiring in one week, opened each week until the long LEAPS gut is paid for. Another case would apply for the risk hedge; LEAPS guts opened and paid for with short-term shorts. This is only one example and the more popular OTM positions could make sense. But the gut strangle presents possibilities that many traders will find attractive. I can see these being useful for several hedging possibilities.

I recently opened an installment purchase strategy, though I wasn't familiar with that term - I just kind of came up with the idea independently. I just looked at your website and found it very thought-provoking. Thanks for an interesting article.

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On 20.10.2018 at 3:16 PM, Kim said:

When you buy a gut strangle, you are long both calls and puts. So intrinsic value is not zero. 

Lets take an example, using AAPL as underlying.

With AAPL around $215, this is a strangle P/L chart (buy 230 call, buy 200 put):
 

image.png

And this is a gut strangle P/L chart (buy 200 call, buy 230 put):

image.png

As you can see, in in strangle case your maximum loss is 100%, but in gut strangle it is only 17%. Of course the gain for gut strangle is also much lower in percentage terms. So yes, in dollar terms, the charts are very similar, but in percentage terms, gut strangle is lower risk lower reward trade.

Hi Kim

So if the theta decay is lower for the ITM GUT STRANGLE, could there be an advantage in using those as hedged gut strangles in exchange for our pre earnings hedged straddles, at least in some cases?

Having higher debit, but lower risk on the gut strangle debit and deriving gains from the short calls and puts?

thank you for your consideration

 

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46 minutes ago, urfiend said:

Hi Kim

So if the theta decay is lower for the ITM GUT STRANGLE, could there be an advantage in using those as hedged gut strangles in exchange for our pre earnings hedged straddles, at least in some cases?

Having higher debit, but lower risk on the gut strangle debit and deriving gains from the short calls and puts?

thank you for your consideration

 

It's an option, but most of the time it would be too expensive in dollar terms for 10k portfolio.

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1 hour ago, urfiend said:

Hi Kim

So if the theta decay is lower for the ITM GUT STRANGLE, could there be an advantage in using those as hedged gut strangles in exchange for our pre earnings hedged straddles, at least in some cases?

Having higher debit, but lower risk on the gut strangle debit and deriving gains from the short calls and puts?

thank you for your consideration

 

Whether it is an ITM "gut" strangle, or OTM strangle, as long as the "strikes" are the same it is an "undefined, unlimited risk" position.

The only way it would fit into another, already existing position would be if that "other" position had the effect of turning the naked strangle into a "defined risk" position.

Otherwise if you are referring to being short this position it has unlimited, undefined risk.

It does not matter whether you are using calls or puts, or whether it is ITM or OTM, as long as you are "short" the same "strikes".

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On 10/20/2018 at 11:17 PM, Kim said:

why use straddles if you can do similar risk profile, with OTM strangle, using less capital?

Because there is a difference between straddles and strangles: volatility skew/smile gives different volatilities depending on strikes. Plus, time decay graph of a straddle is far from a strangle. 

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Percentage wise, P/L of the straddle sits between gut strangle and OTM strangle. Time decay of a straddle is higher than OTM strangle between your initial capital was higher. But percentage loss of the strangle is higher than the straddle. Which makes the gut strangle the most conservative trade (lower loss, lower gain), then the straddle, then the OTM strangle. Further you go OTM, the more aggressive it becomes.

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@DavidR,

Thanks for your recommendation, but
1. How do you know how many years I have been trading options? 2. I'd like to discuss options strategies, not personalities. There is only one thing which is important in trading to me - it's a statement.

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2 hours ago, vasis said:

Because there is a difference between straddles and strangles: volatility skew/smile gives different volatilities depending on strikes. Plus, time decay graph of a straddle is far from a strangle. 

If you are referring to stocks, there isn't a volatility "smile" in the skew.

With stocks it is a diagonal skew which skews up on the strikes below the ATM price, and skews down on strikes above ATM.

With most commodities ( other than equity related ones), there is a "smile" to the skew, with increasing IV equally to both the upside and downside strikes.

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3 minutes ago, cuegis said:

If you are referring to stocks, there isn't a volatility "smile" in the skew.

With stocks it is a diagonal skew which skews up on the strikes below the ATM price, and skews down on strikes above ATM.

With most commodities ( other than equity related ones), there is a "smile" to the skew, with increasing IV equally to both the upside and downside strikes.

Yes, this is why I used "smile/skew" term. One of the examples for a smile - its gold. Moreover, sometimes skew transforms to smile and vice verse. Another thing - when volatility raises skew or smile became more "flat"

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1 minute ago, vasis said:

Opposite example os skew is VXX, where strikes higher than price have higher volatility 

Well, that is a different animal because it basically represents the inverse of stocks and stock indexes.

So, in reality, because it is inverse, the upside is really representing the downside strikes of equity related instruments.

The reason for the type of inflated skew to the downside, and discounted IV to the upside in stocks, is because the trillions of mutual, and hedge fund dollars are "buying" downside protection, and "selling" upside to collect premium against stock holdings, as in covered call type of situations.

VIX/VXX and similar products, are just a representation of the downside skew which is there because of fear of stocks falling.

They sometimes refer to it as the "Fear Index".

Many commodities, such as gold, crude oil etc, behave in the opposite manner.

As prices rise, IV goes up, and it goes up the most on the upside strikes because the dynamics of supply and demand/ vs fear in stocks, creates the different skews.

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56 minutes ago, cuegis said:

Well, that is a different animal because it basically represents the inverse of stocks and stock indexes.

So, in reality, because it is inverse, the upside is really representing the downside strikes of equity related instruments.

The reason for the type of inflated skew to the downside, and discounted IV to the upside in stocks, is because the trillions of mutual, and hedge fund dollars are "buying" downside protection, and "selling" upside to collect premium against stock holdings, as in covered call type of situations.

VIX/VXX and similar products, are just a representation of the downside skew which is there because of fear of stocks falling.

They sometimes refer to it as the "Fear Index".

Many commodities, such as gold, crude oil etc, behave in the opposite manner.

As prices rise, IV goes up, and it goes up the most on the upside strikes because the dynamics of supply and demand/ vs fear in stocks, creates the different skews.

About commodities - usually, but not always. I studied many drops of commodities and volatility skew may behave differently. Another interesting thing of commodities is options on futures - big drops lead to the big spreads between front and back futures giving some additional opportunities in calendar option spreads (especially, natural gas).

Also, its interesting, that puts on VXX are underpriced, when calls are overpriced what makes Kim's "pure volatility" strategy (or debit VXX vertical spreads) profitable in the long term (with, formally, negative theta)

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