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Understanding the Seagull Option Trading Strategy

14 Sep 2023

Options trading allows you to make profits irrespective of what you think about the market. If you feel the market can go up, you can buy call options, and if you think the market can go down, you can buy put options and make significant money.

You must remember you can even wipe out your capital if the market doesn’t move in the anticipated direction. Thankfully, several options trading strategies can help you limit your loss should the market move in the opposite direction. Understanding these strategies can help you protect your investments from adverse market movements while allowing you to gain multi-fold returns in the short term.

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This article discusses one such options trading strategy called the Seagull Option. Continue reading to learn what a seagull option is, how to structure it, and how it can help you safeguard your investment capital.

What is a Seagull Option?

The seagull options trading strategy is a three-legged strategy that involves either two call options and one put option or two put options and one call option. It can be used while trading in currency or stock derivatives to hedge against unexpected price movements.

The seagull option strategy is useful in both bullish and bearish contexts. A bullish seagull structure comprises buying a call spread and selling an out-of-the-money put option. Similarly, a bearish seagull structure comprises buying a put spread and selling an out-of-the-money call option. All options must have the same underlying asset and the same expiry date.

This strategy is also known as the seagull spread, as the structure looks like a seagull (bird) spreading its wings. It helps create a safety net that safeguards you from incurring high losses if the market moves in an unanticipated direction. However, it also limits the maximum gains you can make even if the market moves ultimately in your direction.

How to create a seagull option?

As mentioned, the seagull strategy involves buying a call spread and selling a put option or buying a put spread and selling a call option, depending on whether you have a bullish or bearish perspective. Below are the steps to create a seagull option:

If you have a bullish perspective on the underlying asset:

Step 1 – Buy an at-the-money call option

Step 2 – Buy a bit out-of-the-money call option

Step 3 – Sell an out-of-the-money put option

If you have a bearish perspective on the underlying asset:

Step 1 – Buy an at-the-money put option

Step 2 – Buy a bit out-of-the-money put option

Step 3 – Sell an out-of-the-money call option

Here, you should keep the strike price of the second and third options equidistant from the strike price of the first ATM option. This strategy involves three option contracts, which is known as the three-legged strategy.

The seagull option: An illustration

Now, let’s learn how a seagull option works with the help of an illustration. Suppose the shares of a company are trading for Rs. 120 on the current date. You have a view that this price will rise about 10% in a month, so decide to construct a bullish seagull structure.

- You buy a call option with a strike price of Rs. 120 at a premium of Rs. 4

- You buy another call option with a strike price of Rs. 130 at a premium of Rs. 2

- You sell a put option with a strike price of Rs. 110 at a premium of Rs. 2

If each option has a lot size of 1000 shares, your initial cost to enter the trade is Rs. [(4 x 1000 + 2 x 1000) – (2 x 1000), i.e., Rs. 4,000.

Suppose the price of the shares moves in the favorable direction and closes at Rs. 130 at expiry. In such a case, you can exercise your first option to buy 1000 shares from the seller at Rs. 120. Your net profit would be Rs. [10 x 1000 – 4,000], i.e., Rs. 6,000.

However, if the market moves in the opposite direction and closes between Rs. 110 and Rs. 120, you will incur a net loss of Rs. 4,000. But you can incur a higher loss if the price exceeds Rs. 110.

To conclude

In the case of the seagull option strategy, it’s crucial to select the right combination of call and put options. Therefore, this strategy requires in-depth market knowledge and is not recommended for beginners. If you need a Demat account to begin your trading journey, you can get it for free with Motilal Oswal.

 

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