Seagull Options

Seagull Options – An introduction to this trading strategy

Options are versatile derivative financial instruments that are used to generate non-linear payoffs, i.e. the profit generated by the derivative instrument is not correlated to proportional change in the price of the underlying asset and offers protection against downside risk. They form the most essential component of portfolio hedging and wealth preservation.  In an ever evolving and uncertain world, options offer the best chance to generate above average returns and with the changing world – option strategies have also changed and adopted to new levels of transaction.

What is a Seagull option strategy?

A seagull option strategy is a three-legged option strategy that consists of buying a call option and selling a call and a put option. Alternatively, the strategy also works, when one buys a put option and sells a call and a put options. The strikes must have the same expiry and same underlying asset. The seagull spread is usually used for hedging forex exposure and hedging equity portfolio from a long-term perspective.

Illustration:

Suppose, soon after the launch of the latest model of Pro edition phone, your sibling is off to the US for a short business trip and you want to buy the Pro edition but the price in India is around 12% higher than that in the US. You would obviously look forward to your sibling helping you out with a cheaper purchase from the US as the 12% price differential on a $1200 Pro edition phone is a substantial amount. Now, having convinced your sibling to carry out the purchase at the US store, your biggest worry is no longer about getting your hands on the Pro edition, your biggest worrying factor now is what if the Rupee depreciates?

The USD/INR is currently at 80, one way of mitigating this is to go long USD/INR futures contract, so if the Rupee depreciates to ₹82.00 or even ₹ 85.00, you are covered. But that requires posting an upfront margin. Now, you barely have enough money to buy the iPhone let alone settling mark-to-market obligation, if the USD/INR appreciates instead of depreciating. 

You suddenly recall the Upstox Option strategy builder and punch in data to form a long seagull option spread or importer’s seagull

Long Seagull option spread or Importer’s Seagull option

The long seagull option strategy or importer’s seagull features a combination of Bull call spread (click here) plus a short put option position on an out-of-the-money strike. A bull call spread consists of buying a call option of an at-the-money strike, selling call option of a higher strike that is out-of-the-money and selling a put option at lower strike, which is also out of the money. The two out-of-the-money sold options i.e. call option at higher strike and put option at lower strike, help in reducing the overall cost of the structure. The resultant inflow of premium can often make the seagull option structure a near zero-cost option strategy.

The advantage here is that one seagull option spread overcomes a problem that arises from holding the long USD/INR futures position. And that is the problem of an amplified loss when the price moves in the opposite direction. But with Seagull option spread, if the USD/INR appreciates, meaning its price starts to move below ₹80, the spread provides valuable breathing space by keeping loss at zero, till price reaches ₹78.50, which is the strike price level for the sold out-of-the-money put option, for which you already received an upfront premium that helped convert the seagull option structure to near zero-cost structure. In a conventional long futures position losses would hit you, the moment the pair slipped below ₹80.

Short Seagull option strategy or Exporter’s Seagull option

The short seagull option strategy is initiated by buying an At-the-money put option, selling an Out-of-the-money put option at lower strike and selling an Out-of-the-money call option at higher strike. The two Out-of-the-money sold strikes help in reducing the cost of the structure, usually the premium inflows lead to creating a near zero cost structure.

The short seagull options strategy is most commonly deployed by large exporters, whose substantial cash flows depend on foreign earnings. For an exporter, appreciating INR has a negative impact on earning.  For eg: The exporters is scheduled to receive an inward remittance of $1000 and USD/INR is at 80.00, the net resulting inflow would be (1000 * 80.00) = ₹80,000. If INR appreciates to 78.00 (1000 * 78.00) = ₹78,000  the earnings will drop significantly hurting the exporter. The Short Seagull option spread helps the exporter mitigate against anticipated USD/INR price movement as indicated in table and chart mentioned below.

If the INR appreciates, the exporter is shielded from any loss till 78.50, if INR depreciates - the exporter will not gain anything, but has enough headroom to mitigate the transaction till the USD/INR reaches 81.50 beyond which the spread will start bleeding the exporter.  Usually, such trades are actively managed and the strike which is causing the loss is squared off first. 

The Seagull option strategy can also be deployed to hedge an equity portfolio for a long period of time. Thus, insurancing against falling prices. The near zero cost nature of the structure also helps in keeping the hedging cost lower. The only potential drawback is limited participation in case of rising market prices. This is the opportunity cost the investors have to bear while insuring their portfolio.  A glance at payoff charts would reveal two extended “wings”, which is the reason why the structure is called “Seagull option spread”.

Conclusion

• The Seagull options structure allows investors to place a directional view on an underlying.
• This is done by trading a call or a put debit spread and then selling an out-of-the-money option that helps offset the debit.
• A bullish Seagull can be attractive when an investor is expecting a steady rise in the share price on back of strong fundamentals and sure about the threat of large collapse in price anytime in near future.
• In contrast, a bearish Seagull can make sense when an investor expects a steady decline in the share price with little risk of a huge rally or short squeeze.
• Due to the unlimited risk, Seagull strategies can be dangerous if they are overleveraged and not hedged or closed when the underlying moves against the view.