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What are the breakeven points for the Short Gut Option trading position?
Break even points are the points or spots when there is no profit - no loss for the option trader. i.e. they are the points either side of which there is a profit area and a loss area.
The Short Gut option position will have 2 break even points - one on the upper side and one on the lower side
Upper Breakeven Point of Short Gut option = Net Premium Received + Strike Price of Short Call
i.e. $16 + $45 = $61
If the IBM stock price remains below $61, the Short Gut option position holder will be in profit. If IBM stock price goes above $61, he will be in loss.
Lower Breakeven Point of Short Gut option = Strike Price of Short Put - Net Premium Received
i.e. $55 - $16 = $39
Above $39, the Short Gut option position holder will be in profit. Below $39, he will be in loss.
In summary, the PROFIT region for Short Gut option position is from $39 to $61, while LOSS region is above $61 or below $39.
What is the maximum profit in the Short Gut Option trading?
For the Short Gut option trader (seller), the maximum profit is capped on the upward side as shown in the payoff function.
Profit will be achieved only when:
Price of Underlying remains between the Strike price of the Short Call & Short Put (plus adjusted for the option premium)
Max Profit for Short Gut Option trading = Net Premium Received + Strike Price of Short Put - Strike Price of Short Call - Options Trading Brokerage and Commissions Paid
= $16 + $55 - $45 - Brokerage
= $26 - Brokerage
(for the above example of Short Gut Option trading)
What is the maximum loss in a Short Gut Option position?
The Short Gut option trader will be in loss if the stock price crosses any of the breakeven points on either side. Maximum loss can be unlimited, if the stock price starts to go higher or is it declines well below the call strike price (plus adjustment for option premiums)
Max Loss = Unlimited on the upward side /
Loss for Short Gut Option trading = Price of Underlying - Strike Price of Short Call - Net Premium Received OR Strike Price of Short Put - Price of Underlying - Net Premium Received + Brokerage & Commissions Paid
When is it profitable to trade a Short Gut Option position?
Please note that trading in options is very risky, especially if you are shorting the options. Here in Short Gut Option Trading Positon, you are actually shorting 2 options, and you are taking risk on both the directions of stock movement. A Short Gut Option Trader will also require a lot of margin money.
You will benefit from the time decay of the Short Gut Option Trade, provided the underlying stock price does not move much and remains within your defined range.
The Short Gut option should be traded only when you expect no change or very small range bound movement in underlying stock or index price.
What are the risks in trading Short Gut Options?
Trading Short Guts may look good profit giving trades, but beware of the few things:
- You will get into 2 short positions i.e. 2 sells. Hence you need to keep big amount of margin money with your broker
- You will need to keep a close eye on the underlying price movement. Better to keep strict stop-loss in case of big adverse price movements in the underlying
- Remember, you are getting into a UNLIMTED RISK and LIMITED potential trade when you trade Short Gut Option
- Time decay will work in your favour as option seller (See Options Time Decay: Explained with Examples). In fact, most option sellers short options mainly for benefitting from time decay. It is advised to Short Gut Option when there is less time to expiry (one month or less) as time decay accelarates as expiry nears.
- Increasing Volatility will work against you - it will not only increase the price of the option, but will also increase the chance of big price movements in the underlying.
- This is known as the direction neutral strategy. Only experienced Options traders are advised to get into Short Gut Option Trading position
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