How To Trade Long Guts

I am sure you must have heard of Long Straddle. It is an aggressive option strategy where a trader buys both ATM Call and Put options to make use of a big movement that he anticipates in the stock in the next few days. (It is not necessary to buy ATM strikes only; basically if you buy both Call and Put of the same stock or Index and of the same strike and expiry – you are trading a Long Straddle.)

Long Guts is somewhat similar to Long Straddle, except here the traders buys 1 (or more lots) In The Money (ITM) Call options and same number of In The Money (ITM) Put options.

Construction of the Long Guts

Buy ITM Call Options
Buy ITM (same number of) Put Options

Risk is Limited and Reward is unlimited.

Please see the image below to understand better:

When to Trade Long Guts?

When you anticipate a big movement in either direction – up or down on any stock or Nifty in the near future. The reason can be anything. A big news like budget, quarterly results of a stock, mergers, company buying another company, security threats, company going bankrupt etc. Whenever such a big news is coming, usually there is a lot of trading and the stock moves in either direction sharply.

The trader profits if any of the option i.e. the Call or the Put exceeds the break even point of the trade. It is also important that Volatility also increases. Since both the options are very costly – Volatility has a major role to play in profit or losses in the Long Guts.

How to Trade Long Guts

Note: We will also see that Long Guts is cheaper than Long Straddle even though more money is required to trade this.

1. Calculate Your Max Loss:

Before placing the trade the trader should calculate the maximum loss on the trade. This is how to do it:

Getting real prices:

Feb 02,2015: Nifty is closed at 8800. The Volatility is 20.41.

The trader decides to buy ITM 8600 CE @ 327 and ITM 9000 PE @ 240.

Lets calculate this on one lot only as too much is at stake in this trade. Remember the trader buys In The Money options and they are very costly. This is a big problem with Long Guts. You may need a lot of money to trade this, but still its a better trade than the Long Straddle.

Note: I rarely see traders in India trading the Long Guts for this simple reason that this trade needs a lot of money to play. We are not comfortable putting too much money on risk. 🙂 But we forget – no pain no gain. 🙂

Is this trade really costly? Ok lets see how much money is on risk and also evaluate if more money is risk in this trade or the Long Straddle which is the favorite strategy among aggressive option traders in India:

Money at risk: (327+240) * 25 = Rs. 14,175 + Brokerage. Lets forget the brokerage for now.

However the best part is, this is NOT the trader’s maximum loss. The maximum loss occurs when Nifty is anywhere between the two strikes. Assuming Nifty is exactly at 8800 on the expiry day. Lets calculate the max loss:

8600 CE will be 200 and,
9000 PE will also be 200.
Loss on CE: 200-327 = -127
Loss on PE: 200-240 = -40
Total Loss: -127-40 = -167 * 25 = Rs. -4175.00. This is the max loss.

Now lets compare losses of a trader who traded a Long Straddle (he bought both the 8800 CE and PE)

8800 CE is @ 200
8800 PE is @ 140

If on the expiry day Nifty is at 8800 the trader will lose 100% of the money he used to trade this.

Total loss: -200-140 = -340 * 25 = Rs. -8500.00

Now tell which strategy is more costly? Its obvious that though more money is required to play the Long Guts, it is much cheaper strategy than Long Straddle. 🙂

However this is not the end of story. The trader now needs to calculate the break even points.

2. Calculate the Break Even Points:

Lets calculate the break even points:

327 + 240 = 567

BE For the Call side: 8600 + 567 = 9167
BE For the Put side: 9000 – 567 = 8433

So if on the expiry day Nifty is above 9167 or below 8433 – the trader makes a profit.

Now lets calculate and see the breakeven for someone who traded the Long Straddle the same day.

200+140 = 340

This was done on the 8800 strike.

BE For the Call side: 8800 + 340 = 9140
BE For the Put side: 8800 – 340 = 8460

As you can see there is not much of a difference between the break even points of Long Straddle and Long Guts, but money at risk is less in Long Guts. Therefore it makes sense to play Long Guts than the Long Straddle, if you have a Volatile view on Nifty.

However as expiry comes near the Long Straddle will perform better than Long Guts as they will need small movement to profit. These straddles are available at low rates in the expiry week. In fact you can try this on the expiry day as an expiry day trade. But please be careful – do not buy too many lots. If trying this as expiry day trade, please do not pay too much to trade this. If Nifty closes exactly at the strike where you bought your options; they may expire worthless and you may lose 100% of your investment in the Long Straddle. However this rarely happens. 🙂

3. Knowing the Strike Prices:

In a Long Guts it is very important to know the strike prices which you will buy. You have a problem here. If you go too deep – you will need to pay more. Agreed that max loss will decrease if you go deep into the money but the profit potential will decrease as well. Nifty will have to move significantly to profit. So the best strike prices are those that are slightly in the money.

This means if Nifty is at 8500, you can buy 8400 CE and 8600 PE or 8300 CE and 8700 PE. Maintaining same distance from current spot will make it a neutral non-directional trade. If you are closer to the Call side then it will benefit more if the stock goes up, similarly closer to the Put means it will make money fast if the Stock falls.

Ideally you should go same distance from the spot to select the strikes to keep it neutral.

Going any further than 1 or 2% will almost certainly decrease your chances of making a profit and you may need too much capital to trade. You will feel uncomfortable.

4. Idea of Volatility:

Volatility plays a major role in determining your profit or loss in Long Guts especially if you do not want to wait till expiry. Not waiting till expiry is almost always a good decision because you can always book profits whenever you are making 10 or more points which is 2% of the money blocked.

Who knows on expiry day the long guts will lose its maximum. But if you are OK with the max loss, you can wait till expiry. In my view people waiting till expiry are gambling, not trading. They will make loads of money in 1 trade, and lose it all the very next. And then start from scratch.

Long Guts will make money if there is a movement in one direction and/or Volatility increases. Therefore its very important that you have an idea of Volatility. Usually Volatility increases when there is a big news coming.

You can trade the Long Guts a few days before the news is pending and booking your profits before the news is out. Because if the news is out, Volatility will decrease and both the Call and Put options will lose a lot of their premium.

One example is General Budget. Right now VIX is increasing and I assume it will keep increasing till the Budget is out, end of Feb 2015. After that once the news is out, it will surely shrink.

Another example is when a company is going to declare its quarterly results. You can get in 10-12 days before the results day and get out 1 day before the company announces its results.

Note: Of course if you want to wait till expiry then Volatility is not important. On the expiry day options will have only the intrinsic values. Time and Volatility in the premium will be zero.

5. How to Lock-in Your Profits:

One option will surely increase in value when the Stock moves. Supposing it went down. Now you may feel that people may start buying the stock and it may reverse. So the money you made in the Put option may go. In that case you can either sell the Put option you bought to book profits, or Sell another strike Put option that has increased in value.

For example in our example Nifty was at 8800 when you bought the ITM 9000 PE @ 240 and now Nifty is at 8750, you can sell the 8600 PE at 82 and lock the profits.

Now if Nifty reverses and starts to move up you will lose money from the PE buy, but make money from the PE sell (essentially locking the profits you made from the Put option), and the Call buy. Once you are making reasonable profits from all three trades you can exit.

However please be reminded that this thing is a bit tricky. If Nifty keeps moving down, any more profits coming from the PE buy will be capped and both the PE sell and the CE buy will lose money. So please do your math before taking this step. However it will work wonders if Nifty is range bound. If the newly sold options expires worthless, it will far exceed the losses made from the bought options. 🙂

Therefore you should lock in the profits only when the options have crossed the Break Even points.

Conclusion:

• Long Guts is a trade where the trader has a Volatile view on the stock.
• It is played by buying the In The Money Call and Put options.
• The trader benefits if there is movement in either direction up or down and Volatility also increases.
• Its better to take profits out before expiry because on expiry day the stock may reverse and finish exactly where it started and the trade may lose its maximum.
• Long Guts are better than the Long Straddle because the max loss is a lot less, however the profit potential is almost same.
• However this trade cannot be compounded as too much money is at risk.

If you trade Long Straddle, after reading this article will you start trading the Long Guts? Please let me know in the comments.

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