What Is a Gut Spread?
A gut spread, or "guts spread", is an option strategy created by buying or selling an in the money (ITM) put at the same time as an ITM call. Long gut spreads are used by option traders in instances where they believe that the underlying stock will move significantly, but are unsure whether it will be up or down. In contrast, a short gut spread is used when the underlying stock isn't expected to make any significant movement.
- A long gut spread involves buying an in-the-money call and put.
- A long gut spread profits if the price of the underlying makes a large price move prior to the options expiring.
- A short gut spread involves writing an in-the-money call and put.
- A short gut spread profits if the price of the underlying doesn't move much prior to the options expiring.
Understanding the Gut Spread
A gut spread is different from a typical option spread due to the fact that in a typical spread, out of the money (OTM) options will be used rather than more expensive ITM options.
The ITM options are referred to as the "guts" since they are meatier in terms of intrinsic value than their OTM equivalents.
When buying or selling the ITM call and put, the options should be an equal distance in the money. For example, if the stock is trading at $20, the ITM call could have a strike price of $19.50 and the ITM put could have a $20.50 strike.
If the price moves significantly, the call or put will be worth money, while the other option will incur a loss. The loss on the losing leg is capped at the amount paid for the option.
The long strategy will result in a loss if the price doesn't move significantly, or stays the same, since the extrinsic value of the option will be lost. The loss may only be a partial loss, since one or both of the options may still be in the money and therefore have some value.
Selling an ITM call and put has the opposite intent. The seller, or writer, is expecting that the price won't move very much. Selling an ITM call and put commands a higher premium than selling OTM calls and puts. If the price of the underlying moves significantly, then the call or put will be losing money. The loss could be very big, depending on how far the underlying moves. The loss is offset by the premium received. It is possible that one or both options expire ITM, therefore, the maximum profit is the extrinsic value of the options sold. Risk is unlimited.
Real-World Example of a Gut Spread in a Stock
Assume a trader believes that Apple Inc. (APPL) stock price will have a big move over the next five weeks due to an earnings announcement. They decide to buy ITM call and put options, creating a gut spread, on options that expire in six weeks. This expiration allows the trader to hold through the earnings release.
Apple is currently trading at $225.
They buy an ITM call with a strike of $220 for $12.85 per contract. Since each contract controls 100 shares, the cost for the call is $1,285 plus commissions.
They buy an ITM put with a strike of $230 for $10.40. The put costs a total of $1,040 plus commissions.
The total cost of the trade is $2,325.
If the price of the underlying moves to $240 at option expiry, the trader will still lose $325. This is because the call is worth $20 per share, or $2,000. The put is worth nothing. They spent $2,325 on the trade but only have an option worth $2,000.
If the price moves to $260 at option expiry, the trader has a profit of $1,675. This is because the call is worth $40 per share, or $4,000. The put is worth nothing. They spent $2,325 on the trade.
If the price is near $225 at expiry, the call is worth $5 per contract and the put is worth $5 for the contract, for a total of $1,000 for 100 shares each. They lose $1,325.
If the price of Apple drops to $200, the put is worth $30, or $3,000 for the 100 shares. Deducting what they paid from put profit, they make $675.