Short Gut Spread

How Does Short Gut Spread Work in Options Trading?

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Short Gut - Introduction

The Short Gut is a neutral options strategy that allows an options trader to profit when the underlying stock stays stagnant or within a pre-determined trading range. The Short Gut has the widest profitable range of all neutral options strategies but with also the lowest maximum profit potential. Yes, safety and profit is inversely proportional in options trading. The Short Gut profits primarily from time decay of the extrinsic value of options, putting the greatest enemy in options trading into its advantage. It involves the sale of a Long Gut position so learning the Long Gut first makes the Short Gut easier to understand.

Please Read About The Long Gut.

Find Options Strategies With Similar Risk Profiles

Because you recieve money for writing a Short Gut, it is classified as a Credit Spread. Most other neutral options strategies require you to pay money to put on the trade. Those are known as Debit Spreads. Examples of such Debit Spread neutral strategies that profit when a stock is stagnant would be Butterfly Spreads and Covered Calls.

For implications pertaining to Credit Spreads and Debit Spreads, please go to our Debit & Credit Spreads Page.

When To Use Short Gut?

Use a Short Gut when you expect the underlying asset to trade within a pre-determined trading range or stay stagnant until expiration .

Why Not A Short Straddle or Short Strangle?

The Short Gut has a much wider profitable range than the short straddle or short strangle and therefore allows for more uncertainty. Being a safer neutral strategy than the other two, it compensates by having also the lowest profitability. This is the kind of trade-off in options trading that all options traders should be familar with.

How To Use Short Gut?

Establishing a Short Gut simply involves simultaneously selling to open (or writing) in the money (ITM) call options and an equal number of in the money (ITM) Put options on the underlying asset.

Both short In The Money options offset each other when the underlying stock moves so that movement in the underlying stock do not affect the value of the position negatively while the extrinsic value of both options decay as time goes by, producing its profit.

How deep in the money should the options be depends on how wide you wish the profitable range to be. The deeper in the money the strike price of the call and put options are, the wider the profitable range but the lower the maximum profit as extrinsic values decline as options move deeper in the money. The difference between the strike price of both options and the prevailing price of the underlying stock should ideally be the same. This is so that the delta value of the call and put options offset each other as much as possible, resulting in a delta neutral position.

Short Gut Spread Example Assuming QQQQ at $44. Sell To Open QQQQ Jan39Call, sell To Open QQQQ Jan49Put Notice that the difference between the strike price of both options and the price of the stock is the same at $5 (44 - 39 = 5) (49 - 44 = 5).

Trading Level Required For Short Gut Spread

A Level 5 options trading account that allows the execution of writing naked options is needed for the Short Gut Spread. Read more about Options Account Trading Levels.

Profit Potential of Short Gut :

The Short Gut realizes its maximum profit potential as long as the underlying stock remains within the range bounded by the strike prices of the short call and put options.

Profit Calculation of Short Gut:

Maximum profit is limited to the sum of their extrinsic values.

Short Gut Spread Calculation Assuming QQQQ at $44. Sell To Open QQQQ Jan39Call, sell To Open QQQQ Jan49Put If the Jan39Call is trading at $5.50 and the Jan49Put trading at $5.45, the maximum profit of the position is $0.50 + $0.45 = $0.95.

Risk / Reward of Short Gut:

Maximum Profit: Limited

Maximum Loss: UnLimited

Profitable Range of Short Gut:

The profitable range of a Short Gut is the range bounded by the upper and lower breakeven points within which the position will return a profit. Conversely, it is also the range beyond which the position would start making a loss.

Upper Break Even = Put Strike + Maximum Profit
Lower Break Even = Call Strike - Maximum Profit

Following up on the above example: Upper Break Even = Put Strike + Maximum Profit = $49.00 + $0.95 = $49.95 Lower Break Even = Call Strike - Maximum Profit = $39.00 - $0.95 = $38.05

Advantages Of Short Gut :

:: Able to profit when underlying asset stays stagnant or within a tight trading range.

:: As this is a credit spread position, you are already paid your full profit the moment the position is put on. That reduces risk.

:: Higher chance of ending up in full profit than a short straddle or short strangle.

:: If volatility is high when the position is put on, a drop in volatility after the position is put on can result in a profit.

Disadvantages Of Short Gut:

:: Lower profitability than the short strangle or short straddle.

:: Potential loss is unlimited and can collect to very big amounts if the underlying stock continues strongly in one direction.

:: Because of this risk, the margin requirements for this strategy are fairly high. Your options broker may require you to cover both options as if they were two Naked Options, or they may require a cash value of the Option Strike Price plus the highest bid of the call or the put.

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