Neutral Short Guts - A Complete Guide

There are so many strategies available in the landscape of options trading, some aimed at beginners, others reserved for seasoned traders.

One of the simple options strategies suitable for those getting started in the world of options is Short Gut. It is one of the trading methods used in neutral markets to minimise risks and gain profits.

In this guide, let us look at the Neutral Short Guts strategy and try to understand how it works and how options traders can use it.


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Neutral Short Guts

What is a Neutral Short Guts Strategy?

The options strategy allows traders to reap gains from a trade when the underlying security price stays within a range for a specific time.

A limited profit, undefined risk options trading strategy is initiated when the trader believes the stock will see a little volatility shortly. The Neutral Short Guts is a credit spread because you receive a net credit for writing the trade.

The strategy involves selling one ITM call, and one ITM put simultaneously for the same security at the same expiration date. It is quite similar to strangle short and short straddle; the difference is that the Short Guts gets you gains from a wider price range than others.

However, the overall potential profits are lesser than other options strategies and should be used carefully.

When to Use the Strategy?

The Neutral Short Guts strategy is designed to be used when you have a relatively neutral outlook on underlying security. Still, you believe there will be a little movement in either direction.

Traders use this strategy when they expect the asset to trade within a range or stay stagnant for some time before expiration.

However, if the asset price moves significantly in either direction, substantial losses can be unlimited. You should be confident that such a move will not occur before initiating the trade with this strategy.

Though a credit spread is created, you also need a margin that requires sufficient capital to use the Neutral Short Guts.

Risk Profile

The Neutral Short Guts strategy realises the maximum profit potential, which is limited and occurs as long as the asset stays within the range bounded by the strike prices of the options. At a price, both the options expire ITM and become worthless. This loss of value in the time that the strategy converts into profit for the trader.

The strategy has a high risk to reward ratio as traders can expect huge losses when the security makes a strong move either upwards or downwards when expiring. However, you can buy back the options at any time before expiration and close positions to limit the losses.

Practitioners of such plays anticipate massive losses only due to large 'Black Swan' events, which are rare, and the strategy can be used to generate consistent income until then.

Traders also need to be well-versed with trade management, which can hedge and minimise losses at times of high volatility, resulting in the trade going against them.

This strategy is also popular among mutual fund houses, which maintain a large basket of securities that can be used as a hedge against adverse price movements. Funds write options on securities held to enhance returns for investors.

How to Create a Trade Using the Neutral Short Guts Strategy?

  • Initiating a Short Guts involves two simultaneous trades – writing ITM call option and the same number of ITM put options on the security.
  • Both the contracts should have the same expiration date, and they can be as near or as long term as you like.
  • A short-term expiration implies lesser time for the security to move, but these options have a lower extrinsic value.
  • As traders profit from the significant extrinsic value of falling options, lesser value means lower potential profits. Long-term contracts deliver more potential profit, but they need more time for the asset price to move enough to incur a loss.
  • Another decision a trader should make when creating Neutral Short Guts is how far in the money the contracts are.
  • The put options and call options must be ITM by the same amount, which means the strikes should have an equal distance from the present trading price of the asset. However, you need to determine how far the strikes should be from the current price.

The farther ITM the options are, the bigger the price range you can profit from. However, as options move farther, the extrinsic value falls, making the potential profit. The decision ultimately depends on whether you want to increase the size of your profit or the chances of making a profit.

Example

Let us consider an example to understand how the Neutral Short Guts strategy works. A Company B stock trades at $50, and a trader expects the price to remain close to $50 in the near future. ITM call options with a strike price of $45 trade at $6, so he writes a contract with 100 options for a credit of $600. This is his Leg A.

ITM put options with strike $55 are trading at $6, so he also writes a contract of 100 options for another $600. This is Leg B. The trader has now created a short gut for a net credit of $1200.

This spread remains profitable as long as the stock price remains between Leg A and Leg B. Here, he would want the price to be somewhere in the range of $45 to $55. Throughout the range, the trader gets the same profit, more or less, regardless of the exact point of price, and is the maximum profit he can make.

When the underlying asset remains in a specified range, a trader has liabilities on both legs, which is limited. The greater the price of the stock, the higher the liability on Leg A and the lower the liability on Leg B. On the other hand, the lower the underlying asset price, the lower the liability on Leg A and the higher Leg B.

Here are some possible scenarios that show how the strategy works in practice.

  • If the Company B stock falls at $50 upon expiration, the Leg A options would be worth $5 each creating a liability of $500, and those in Leg B would also have the same worth and liability. So the liability will be $1000, which gets deducted from the initial credit to make a net profit of $200.
  • Suppose the stock price rises to $53 upon expiration, the Leg A options get worth $8 each to create an $800 liability, and Leg B options would be $2 each with a $200 liability. The total liability will come to $1000 again, and the net profit will be $200.
  • If, on the other hand, the company’s stock price fell to $46, Leg A options would be around $1 each creating a liability of $100, and those in Leg B would be around $9 each, which means a $900 liability. The total liability is again $1000 giving a net profit of $200.
Stock Price at Expiration Net Payoff from $45 Call Option Sold Net Payoff from $55 Put Option Sold Net Payoff ($)
$50 $100 $100 $200
$53 -$200 $400 $200
$46 $500 -$300 $200
$43 $600 -$1,200 -$600
$40 $600 -$1,500 -$900
$60 -$1,500 $600 -$900

As you can see from these scenarios, the liabilities and the profit amount remain the same regardless of where the stock price ends at expiration as long as it remains in the specified range. The gain you make is the amount of extrinsic value the options had when you wrote them, which erodes by the expiration date.

The strategy can also be profitable if the asset moves a little outside the range, but the profits shrink as they get farther outside. If it goes too far, it will start returning a loss, and the strategy can incur unlimited losses.

Pros and Cons

Upsides

  • It can be profitable when the security stays within a range
  • Higher chance of getting a full profit
  • As it is a credit spread position, the risk is reduced
  • If the position is put in high volatility, a drop in volatility can give a profit

Downsides

  • Lower profitability than short straddle or short strangle
  • Unlimited loss potential can get big if the asset keeps moving strongly in a direction
  • As the risk is high, the margin required is quite high

Summary

A Neutral Short Guts strategy can help traders earn significant profits from an extensive range of security prices, but the potential returns are much lesser than other similar strategies. The maximum profit you can make with the strategy is limited, but there is no limit on potential losses which means it involves many risks. Therefore, traders should use the strategy only when they believe the underlying asset has little to no chance of moving outside the strikes you define.

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