Seagull Option

The seagull option is an advanced trading strategy used in the currency (forex) markets to hedge against unexpected price movements. It involves a specific combination of call and put options to limit risk. This strategy is named after the seagull bird because the profit & loss diagram resembles the wingspan of a seagull. 

In this article, we will explain what a seagull option is, how it is constructed when it should be used, and the main pros and cons of this approach. 

What is a seagull option? 

A seagull option gets its name from its payoff diagram, which looks like the wings of a seagull. It is a 3-legged option trading strategy consisting of two call options and one put option (or vice versa). It aims to reduce risk in fx options seagull trading by limiting losses while still allowing for some gains if the currency moves favourably.

The structure of a seagull option strategy

There are two ways of structuring a seagull option strategy:

1. Bullish seagull spread 

2. Bearish seagull spread

Let’s examine both these formations.

1. Bullish seagull spread

A bullish seagull option consists of two components:

• Bull Call Spread – This includes buying a lower strike call option and selling a higher strike call option. Since the sold call earns premium income, a bull call spread is also known as a debit call spread. 

• Short/Naked Put – This entails selling a put option positioned at a strike below the underlying asset’s market price.

For example, consider an active trader who expects the USD/INR rate to rise moderately over the next month from the current market price of ₹75. Here is how she can structure a bullish seagull spread:

– Buy 1 lot USD/INR 76 call at ₹2 

– Sell 1 lot USD/INR 78 call at ₹1 

– Sell 1 lot USD/INR 73 put at ₹3 

So the net investment for the trade comes down to just ₹2 – ₹1 + ₹3 = Positive ₹4

2. Bearish Seagull Spread 

On the flip side, the bearish version contains these legs: 

• Bear Put Spread – Formed by purchasing a higher strike put and writing a lower strike put to earn some premium

• Naked/Uncovered Put – Involves selling an out-of-the-money call option  

For instance, if the trader expects the USD/INR to decline mildly, she can initiate this bearish structure:

– Buy 1 lot USD/INR 73 put at ₹2

– Sell 1 lot USD/INR 71 put at ₹1 

– Sell 1 lot USD/INR 78 call at ₹3

Here again, the net investment is only ₹2 – ₹1 + ₹3 = Positive ₹4

When does it make sense to use a seagull spread? 

A seagull spread works well when moderate movement in either direction is expected in the short term, but the trader is still determining which way. Specific situations where this strategy can prove worthwhile are:

1. During major events like elections, monetary policy changes where some volatility is definite, but the extent and direction are ambiguous
2. In assets that regularly display bounded movement, such as land or even currencies  
3. When implied volatility rank in options is very high so, premium selling helps lower the cost
4. To take advantage of mean reversion tendencies typically seen after sharp spikes 

The seagull is quite popular in forex trading because currencies often oscillate in set ranges and react to news events. The lower debit from sold options allows participation without excessive risk.

Analysing the benefits of a seagull option  

After understanding its applications, we next assess the major advantages of using a seagull spread:  

• Downside protection from adverse moves via the put/call spread  
• Zero cost seagull option due to premium earned from naked call/put
• Ability to capture moderate profits from favourable currency fluctuations
• Helps prudently trade around events with uncertain outcomes 
• Requires smaller investment compared to sole long call or put positions
• Allows flexibility to exercise the most suitable leg before expiration  

What are the drawbacks of implementing a seagull? 

However, there are a few limitations of this technique that should also be evaluated:

• Caps the profits if the underlying asset trends strongly in either direction
• Complex 3-legged involvement can intimidate amateur option traders
• Needs active monitoring and foresight in timing key events  
• Bid-ask spread on options can erode net profits to some extent

Constructing a seagull option

Here is a step-by-step process to construct a seagull option:

1. Decide on a bullish or bearish seagull based on the market view 

2. For a bullish seagull – buy the OTM call option & sell a higher strike call at suitable strikes

3. Sell OTM put option below market price to fund call spread purchase

4. For bearish seagull – initiate OTM put spread & sell OTM call

5. Align entry cost, exit goals, and option expirations 

6. Actively track the progress of currency pair and economic indicators

7. Exit positions before expiry based on predetermined goals

Getting the timing right on entry, strikes, and holding periods is crucial to use this strategy effectively. Active monitoring is then essential to capture profits at the desired points.

Should you use a seagull option?

For amateur traders who are starting, the complex combinations of options and the need for nuanced analysis are best avoided. Mastering the basics of simple long calls and puts, their sensitivities, and getting a strong grip on market drivers are far more essential currently. So retail traders are advised to stay away from exotic structures like the seagull spread as of now.

But for institutional and seasoned traders active in the global currency markets, the seagull offers an efficient way to enable participation without overextending risk limits. Hedging via a seagull is especially useful around events, geopolitics, and policy decisions where a mild range-bound move is anticipated, but directional uncertainty looms large. The limited profits are sacrificed instead of retaining an outcome-agnostic risk profile.

Eventually, the decision depends hugely on one’s level of options proficiency, individual view on upcoming market events, and the type of trading strategy being pursued overall. Opting for a seagull spread just because it sounds fascinating does more harm than good. Aligning its use tightly with broader portfolio goals is the real key to harnessing its benefits.

Conclusion 

A seagull option can be an efficient hedging technique for experienced options traders active in the currency segment. It typically involves a put/call spread plus a sold put/call, structured based on market outlook. 

By selling an option, zero cost seagull options limit losses from adverse moves due to the spread while still allowing for moderate profits if currencies move favorably. Moderate profits are possible if currencies move favourably. However, sharp upsides/downsides are not captured. So, a seagull option offers a prudent strategy but requires expertise to implement it properly.

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