DEFINITION of Gut Spread
A gut spread, or "guts spread", is an option strategy created by buying or selling an in the money put at the same time as an in the money 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 gut spread is different from a typical option spread due to the fact that in a typical spread, out of the money options will be used rather than more expensive in the money options. Theoretically, however, once hedged a regular spread and the equivalent gut spread should behave identically.
BREAKING DOWN Gut Spread
A trader may prefer a gut spread over a regular spread if they perceive that they can get a more advantageous price using the in the money options. The in the money options are referred to as the "guts" since they are more meaty in terms of intrinsic value than their out of the money equivalents.
Examples of Gut Spreads
A typical option spread strategy is known as a collar, or risk reversal. Say a trader wants to put on a collar in XYZ stock, which is trading currently at $50. He may purchase the 40 strike put and sell the 60 strike call while buying shares of the stock at $50. Both the 40 put and the 60 call would be considered out of the money, since the 40 put gives the trader the right to sell the stock at $40 - but he wouldn't exercise that right since the stock could be sold in the market for $50. Similarly, the 60 call is out of the money since it gives the trader the right to buy the shares at $60, but he can but them for $10 less in the market.
A guts risk reversal, however, would involve buying the 40 call and selling the 60 put - as well as selling stock in this case. Both the 40 call and 60 put are in the money since both have $10 of intrinsic value built into them.
The guts can also be used in combinations, as well as spreads. For example a strangle is a strategy for buying (or selling) both an out of the money call and out of the money put in the same expiration month on the same underlying security. For instance, a trader who believes that price of XYZ stock will move significantly in the next few months but is not sure about whether it will go up or down may buy the 45 - 55 strangle by purchasing the 45 put and also purchasing the 55 call. To buy the guts strangle instead, they would buy the 45 call and the 55 put.