The bullish version combines a bull call spread (debit) with an OTM short put. The bearish version combines a bear put spread (debit) with a short OTM call. The most popular seagulls are either bull call or bear put spreads, but they can also be designed as opposites, bear call, or bull put spreads.
This strategy, like so many hedges, has a tradeoff. The risk is limited, but the gains are also limited. The seagull’s short side helps lower the cost of the debit spread and, if structured properly, could bring the net cost down to zero. However, the more value the short position has, the greater the risk of loss due to the underlying movement beyond the net charge on the position.
This can also be viewed as a one-sided hedge where either the downward or upward price movement can be controlled, but not both. It is desirable to get as close as possible to the seagull. This is based on the identification of a common problem: with a net charge, the required underlying price movement must be greater than with a zero premium position.
Assumptions always go into the development of such a safeguard. A trader typically uses a seagull or similar strategy during periods of high volatility for the underlying asset, but is likely to decline, possibly due to a cyclical timing trend over the past few weeks or months. At the same time, there may be a lack of clarity about the direction of price movement as volatility decreases. In this situation the seagull is an effective safety device.
For example: The underlying asset is trading at $ 123 per share. A trader buys a bullish call spread. Buy the 123 call for 41 and sell the 123.50 call for 20 (both have the same expiration date and this results in a net charge of 21. Next, sell the 122.50 put for 17 with the same expiration date. The Net cost of this trade is now reduced to 4 (41 – 20 – 17 = 4).
The challenge in the seagull is twofold. First, it is desirable that the premium be as close to zero as possible. In the example, the net of 4 is not too far away from it. Second, the mix of calls and puts and their expiration makes sense based on the treacher’s assumptions about volatility and the underlying price.
Other factors should also influence the timing of the expiry and the selection of the underlying asset. If there is an ex-dividend date or a profit announcement before the expiration date, volatility can be affected, if only temporarily. However, these events will affect the selection and timing of all stock options and can have potentially devastating effects on the hedge itself, especially if early exercise is possible. For revenue, this may be more of a problem with the seagull combining short calls and long puts, but it is a mistake to overlook the potential impact of poor position timing due to possible unexpected surprises.
The seagull can be modified so that both expectation and risk can be expanded in some way. For example, a trader can use the seagull to hedge long stocks by selling an ATM call and buying an OTM put. This makes the “body” a short position and the “wings” are long. This is the opposite structure in the previous example, which was a short seagull. This reversal leads to a long spread of the seagull. This is a low cost version of hedging risk, but takes into account the opportunity to benefit from a rally in the underlying asset.
The value of using combinations of hedges deserves further consideration. Traders are looking for solutions to the risk-reward equation. The “perfect” strategy offers unlimited profits with little or no risk. It doesn’t exist either. Is it worth evaluating spreads with profit and risk limits – like the seagull? Given the need to tie up capital for short-side collateral, a trader needs to compare that to actual potential and risk.
It’s easy to overlook the restrictions on distribution like this. The same problem arises with many strategies, even the ever popular covered call. The online literature and commentary focuses on returns and avoidance of exercise, but almost never mentions the limits of covert calling. The maximum gain is always limited, but the maximum loss is not. This doesn’t make covered calling a bad strategy, but traders need to be aware of these factors when making a trade. With covered calls, winnings can never exceed the call premium, but losses can arise in two ways. First, if the underlying asset rises above the strike, the missed opportunity can be significant. Second, if the underlying asset falls below the net base (cost of the stock less call premium), it may not be possible to restore position immediately or not at all. This depends on the future price movement.
The same restriction applies to all forms of coverage. In the case of the seagull, long and short are then offset with the aim of approaching a net premium of zero. For traders, this means perfect protection that offers profit potential without net costs. However, risk balancing can be important in pursuing perfection. The seagull can be an attractive strategy for traders who do not take risks and whose volatility and price direction are high – or at least for traders who are willing to accept the known risks. Other traders may view the seagull and similar hedges as gimmicks whose limited profit potential does not justify the risk. It is an individual decision that is best made with full awareness of both sides of the hedge.
Michael C. Thomsett is a widely published author with over 80 business and investment books, including the best-selling Get started with options coming in its 10th edition later this year. He also wrote the recently published The math of options. Thomsett is a frequent speaker at trade shows and blogs, as well as on Seeking Alpha, LinkedIn, Twitter, and Facebook.