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 also can be designed as opposites, bear call or bull put spreads.
There is a trade-off in this strategy, like so many hedges. Risk is limited but profits are also capped. The short side of the seagull helps reduce the cost of the debit spread, and if properly structured, could take the net cost down all the way to zero. But the more value in the short position, the greater the risk of loss due to underlying movement beyond the net debit of the position.
This can also be viewed as a one-direction hedge in which either downside or upside price movement can be controlled, but not both. It is desirable to get as close as possible to z zero debit in the seagull. This is based on recognition of a common problem: With a net debit, the required underlying price movement must be greater than for a zero-premium position.
Assumptions always go into development of a hedge such as this. A trader usually will use a seagull or similar strategies in times of high volatility for the underlying, but expected to decline, perhaps in observation of a cyclical timing tendency in recent weeks or months. At the same time, there may be a lack of clarity about the direction of price movement with declining volatility. In this situation, the seagull is an effective hedging device.
For example: the underlying trades 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 sets up a net debit 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, the desirable net is to end up with premium as close as possible to zero. In the example, the net of 4 is not too far from this. Second, the mix of calls and puts and their expirations make sense based on the treader’s assumptions about volatility and underlying price.
Other factors should also influence the timing of expiration and selection of the underlying. If there will be an ex-dividend date or earnings announcement before expiration date, the level of volatility could be influenced, if only temporarily. However, these events affect the selection and timing of all options on equity underlyings, and they can have a potentially devastating affect on the hedge itself, especially if early exercise is a possibility. For earnings, this may be more of an issue when the seagull combines short calls and long puts, but it is a mistake to overlook the possible ramifications of timing the position poorly due to possible unexpected surprises.
The seagull can be modified, so that the expectation as well as risk can be expanded in some way. For example, a trader may use the seagull to hedge long stock 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 sets up a long seagull spread. This is an inexpensive version of hedging downside risk, but while allowing for the possibility of profits from a rally in the underlying.
The value of using hedge combinations deserves further examination. Traders find themselves seeking solutions to the risk/profit equation. The “perfect” strategy offers unlimited profits with little or no risk. It also does not exist. In evaluating spreads with limits on both profit and risk – like the seagull – is it worthwhile? Considering the need for commitment of capital for short side collateral, a trader needs to compare that to the true potential and risk involved.
It is easy to overlook the limitations in spreading like this. The same problem is found in many strategies, even the ever popular covered call. The literature and commentary online focuses on rates of return and exercise avoidance, but almost never mentions the limits to covered calls. Maximum profit is always capped, but maximum loss is not. This does not make covered calls a bad strategy, but traders need to be aware of these factors as they pursue any trade. With covered calls, profits can never be greater than the call premium, but losses can accrue in two ways. First, the missed opportunity when the underlying rises above the strike can be considerable. Second, if the underlying falls below the net basis (cost of shares minus call premium), it may not be possible to recover the position immediately, or at all. It depends on future price movement.
The same limitation applies to all forms of hedge. The seagull involves then offset of long and short with the aim to approach zero net premium. To make traders, this translates to a perfect hedge, one offering profit potential at no net cost. However, the risk offset can be significant in pursuing perfection. The seagull may be an attractive strategy for traders fully away of risks and whose sense of volatility and price direction is strong – or at least for those traders willing to accept the well-known risks. Other traders may end up viewing the seagull and similar hedges as gimmicks whose limited profit potential does not justify the risk. It is an individual choice, best made with full awareness of both sides of the hedge.
Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.