The equity markets have bounced back post the pandemic waves and have been regularly reaching new heights in the recent period. This has raised the excitement levels in the market, the evidence of which can be seen due to a flurry of Initial Public Offers (IPOs) being launched lately. This, in turn, has encouraged several new investors to try their hands in trading during this current bull run. But a bull run also comes with associated volatility and the discussion around whether such high market levels are sustainable.
There are several popular investment and trading strategies like the bear option, bull option, butterfly option, among others. Investment strategies should be developed based on experience, understanding of the market mechanisms, and risk appetite, among other factors. There is a lot of reading material and content available to describe these frequently used investment strategies and what they entail.
The seagull option is also a type of trading strategy which may not be as often discussed as some of the others mentioned. This could also be due to the fact that it is as commonly used and requires a high level of trading insight. In this blog, we will try to explain what the seagull option is, how it is structured, the situation it is used in and how it can help safeguard your investment portfolio.
Seagull Option – An Overview
The seagull option strategy is often applied during forex or currency trading with the intention of providing a hedge against the unexpected movement of an asset. The process is often referred to as a three-legged strategy and involves using a combination of purchases and sales on the currency options involved in an attempt to keep the associated risk level of the investment within reason. Also known as ‘seagull spread’ due to the wingspan of the bird, the use of a seagull option is useful and relatively inexpensive, especially considering the safeguard it can provide to your investment portfolio.
Seagull Option Structure Explained
The structure of a seagull option typically constitutes the buying of a call spread and the selling of a put option. It can be the other way round as well, depending on the asset being traded. It can often constitute two call options and a put option or vice versa and can be used in both bullish and bearish contexts. While the bullish seagull option strategy involves a bull/debit call spread and the sale of an out of the money put, the bearish strategy is just the opposite and includes a bear put spread and the sale of the money call.
The aforementioned structure of the seagull option enables the creation of a safety net that helps in protecting the investor from incurring a loss on the currency trade. On the flip side, it may also limit your potential gains. This arrangement provides the investors with the flexibility to exercise whichever option is deemed more apt based on the corresponding movements taking place on the forex market, and still be able to generate some return from the trade. While this can act as a security net due to its hedged position, it can also result in mediocre returns in case the asset moves too far in the wrong direction from your original estimations. As you would have noticed, combining a long put spread with a short call or vice versa is good protection against falling prices, however, this strategy is also known to limit your participation in rising prices.
As is the case with any type of investment strategy, one needs to carefully choose the right combination of puts and calls. The timing of the expiration dates for the options also needs to be aligned with the anticipated movement in the currency exchange rates. To make the most out of the seagull option strategy, it is important that the call and put options involved are similar in terms of amount, and that the options are priced in a manner that will effectively create a zero-sum game. This is how it insulates you from situations with perceived high volatility.
While the seagull option acts like insurance for your portfolio in case of high volatility, if the exchange rate does not move significantly during the trading window then your returns might be modest leading to potential opportunity costs.
Using the seagull option effectively requires a fair amount of experience and knowledge in trading and is not advisable for beginners or amateurs. The need for market research, recent performance trends and gains/falls of the currency being traded are of high importance while using this investment strategy. The seagull option strategy does help to reduce a certain amount of risk involved, but can not completely remove all volatility involved in forex trading. Hence all factors should be considered before its application in your portfolio.