Manoj Kumar Jain

Short Gut Spread – Options Strategy for a stable stock market

If you want to make money in a stable stock market which is not very volatile at the moment and you expect it to stay within a specific range; one of the strategies you can apply is the Short Guts Option Strategy. It is a market-neutral trading strategy involving simultaneous sale of an in-the-money (ITM) Put option and an ITM Call option. It is designed to produce a limited maximum net profit; when the market stays between the expected range decided by the investor.

Before we dive into an example, let’s first understand what is the potential upside and downside when applying this strategy.

Limited Upside

You can make money in a stable stock market up to a maximum limit using this strategy. The Short Guts Option Strategy provides a limited Maximum gain that can be earned by the investor and this gain happens when the market remains within a specific range that the investor expects at the time of investing.

Unlimited Downside

This strategy provides a limited potential of maximum gain, the same is not true for maximum loss; as the downside potential is unlimited in this strategy. It might seem strange and this is one of the reasons why many investors prefer to stay away from a gut spread.

However, an important thing to note is that if you use it carefully and select the range properly, then you can significantly reduce the probability of the downside happening, and that is what makes this strategy attractive.

Example

Now that we have understood the upside and downside potentials, let’s take a look at an example to understand how to apply the Short Guts Option strategy.

Below are the assumptions for a share of Company X:

Current Market Price (CMP):       540
Premium for 1-month 600 PE:      80
Premium for 1-month 500 CE:      60

Now, we will sell both CE and PE. Premium earned: Rs. 140

Fast forward 1 month later; at the time of expiry of both the options, either of the below scenarios can happen:

Scenario 1: As expected, stock price remains between 500 and 600. Both the options will be exercised as they are in-the-money. We will purchase shares through PE at 600 and sell through CE at 500. It might seem like we are making a loss of 100 on each share, but we had already earned 140 through premium so our net profit in this scenario is 40 per share.

Scenario 2: Stock became bullish and the price went above 600. PE will be out-of-money so it will lapse. CE will be in-the-money and we will have to settle the trade by purchasing the share at market price and selling it for 500. But we have earned 140 premium and it will act as a cushion now, which makes our breakeven point as 640 (500+140), so we are safe so long as the price remains below 640. We will start making a net loss if the share price goes beyond 640.

Scenario 3: Stock became bearish and the price goes below 500. CE will be out-of-money so it will lapse. PE will be ITM and we will have to settle the trade by purchasing the shares at 600 each. However, we had earned a premium of 140 already and we have that cushion, so our breakeven point becomes 460 (600-140). This means that we will stay in profit so long as the market stays above 460. We will start making a net loss if the stock falls below 460.

Conclusion

Short Guts Option strategy uses a gut spread to provide the investors an opportunity to earn a net-profit in a non-volatile security. In our example above, our upper breakeven point is 640 and lower breakeven point is 460; we have essentially created a scenario where we will stay in profit so long as the market remains between 460 and 640. This is quite a wide range and provides an excellent cushion to the investor on both the sides for a share with CMP of 540.

Do check out MKJ sir’s video on this strategy by clicking on this link.

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