What is a Seagull Option?
A bullish seagull strategy involves a bull call spread (debit call spread) and the sale of an out of the money put. The bearish strategy involves a bear put spread (debit put spread) and the sale of an out of the money call.
Options spreads are already hedged positions that limit risk but cap potential profits. Adding the short position in the other options further helps finance the position and possibly bring the cost to zero. However, it introduces increased loss potential if the underlying asset moves too far in the wrong direction.
Put another way, a seagull option is a one-direction protective technique whereby either downward or upward movements can be reined in, but not both. While the seagull strategy typically involves bull call spreads and bear put spreads, they can also involve the opposite using bear call spreads and bull put spreads.
- A seagull option is a three-legged currency options trading strategy to minimize risk. It is implemented using two puts and a call or vice versa.
- If there is no significant movement on the exchange rate, then returns might be modest using this trading strategy.
Basics of Seagull Option
The options contracts must be in equal amounts and are normally priced to produce a zero premium. This structure is appropriate when volatility is high, but expected to fall, and the price is expected to trade with a lack of certainty on direction.
In the second example above, a hedger uses a seagull option structured as the purchase of a call spread (two calls), financed by the sale of one out of the money put, ideally to create a zero premium structure. This is also known as a "long seagull." The hedger benefits from a move up in the underlying asset's price, which is limited by the short call's strike price.
How to Construct a Seagull Option
Here is an example where volatility is relatively high and the trader expects the price of the underlying asset to rise while volatility falls.
In this example, the euro is trading at 1.2303.
First, buy the bullish call spread with a purchase of the 1.2300 call (for 0.0041) and sell the 1.2350 call (for 0.0020). Both for the same underlying asset and expiration date.
Next, sell the 1.2250 put (for 0.0017) with the same expiration date. The net cost for this trade would be 0.0041 - 0.0020 - 0.0017 = 0.0004
Finally, tweak the strikes as necessary to bring the premium (cost) down close to zero.
As with any type of trading strategy, it is imperative to choose the right combination of puts and calls. It is also important to make sure the expiration dates for the options are in line with the expectations for presumed changes in price and volatility. While this particular option strategy will help to reduce the level of risk assumed by the trader, the arrangement does not completely remove all volatility. There is still the chance that the return will be more modest than anticipated, especially if the movement on the exchange rate is not as significant as anticipated.