The bullish version combines a bull call spread (debit) and an OTM short put. The bearish version combines a bearish put spread (debit) and a short OTM call. The most popular gulls are bull call or bear put spreads, but they can also be designed as opposite bear call or bull put spreads.
As with most hedging, this strategy has tradeoffs. The risk is limited, but the profit is also capped. The short side of the seagull can help reduce the cost of debit spreads and, if configured properly, can bring the net cost down to zero. Greater risk of loss from a fundamental move beyond
This can also be viewed as a one-way hedge that can control price movement either up or down, but not both. It is desirable to get as close as possible to the seagull’s z zero debit. This is based on an awareness of common problems. For net debits, the required underlying price movement must be larger than for a zero premium position.
Developing such hedges always involves assumptions. Traders typically use seagulls or similar strategies during periods of high volatility in the underlying asset, but they are likely to observe cyclical timing trends in recent weeks or months and expect to see a decline at the same time. , with lower volatility, the direction of price movement may be unclear. In such situations, seagulls are an effective hedging tool.
Example: The underlying trade is $123 per share. A trader buys a bullish call on his spread. Buy a call of 123 at 41 and sell a call of 123.50 at 20 (both have the same maturity date, which sets a net debit of 21. Then sell a put at 122.50 with the same maturity date at 17. This trade is now down to 4 (41 – 20 – 17 = 4).
Seagulls have two challenges. First, the desired net is to have premiums as close to zero as possible. In the example, the net of 4 is not far from this. Second, call and put combinations and their expiry dates make sense based on traders’ assumptions about volatility and underlying asset prices.
Other factors should also influence expiration timing and choice of underlying. If there is an ex-dividend date or earnings announcement before maturity, the level of volatility may be affected, even temporarily. However, these events affect the selection and timing of all options on equity underlyings and can have devastating effects on the hedge itself, especially if early exercise is possible. In terms of earnings, this could be more of an issue if Gull combined his short his call with a long put, but there could be some unexpected surprises, so it’s a good idea if the position is badly timed. It is a mistake to overlook the impact.
Seagulls can be changed, so the expectations as well as the risks can be expanded in some way. For example, traders can use Gull to hedge long holdings by selling ATM calls and buying OTM puts. This puts the “body” in the short position and the “wing” in the long position. This is the opposite structure from the previous example, which was a short gull. This inversion sets the long seagull spread. This is a cheaper version for hedging downside risk, but allows for the possibility of profiting from the rise of the underlying asset.
The value of using hedging combinations deserves further consideration. Traders find themselves looking for solutions to the risk-profit equation. A “perfect” strategy offers unlimited profit with little or no risk. Also does not exist. Like seagulls, is there value in evaluating spreads that have limits on both profit and risk? should be compared with the associated risks.
It is easy to overlook the limits of such diffusion. The same problem is seen with many strategies. Even the ever-popular covered call. The online literature and commentary focuses on return rates and exercise avoidance, but rarely mentions limits on eligible calls. there is not. This does not make covered calls a bad strategy, but traders should be aware of these factors when placing trades. Covered calls never exceed the call premium, but they can lose money in two ways. First, the opportunity lost if the underlying exceeds the strike price can be substantial. Second, if the underlying falls below net basis (equity cost minus call premium), the position may not recover quickly or at all. It depends on future price movements.
The same restrictions apply to all forms of hedging. Seagull then offsets longs and shorts with the goal of bringing the net premium closer to zero. To make traders, this translates into a perfect hedge, offering potential profit at no net cost. However, offsetting risk can be important in the quest for perfection. Seagulls may be an attractive strategy for traders who are completely risk averse and have a strong sense of volatility and price direction, or at least those who are willing to accept well-known risks. Other traders may end up viewing seagulls and similar hedges as gimmicks where the limited profit potential does not justify the risk. It is best to do
Michael C. Thomsett is a widely published author of over 80 bestselling business and investment books. An introduction to options, will publish its 10th edition later this year.he also recently released Mathematics of optionsThomsett is a frequent speaker at trade shows, blogs, Seeking Alpha, LinkedIn, Twitter and Facebook.
