How To Purchase Crash Insurance For "Free" - Seagulls/3-ways/Put Spread Collars

Posted by Alexander Grant on 1/19/22 8:54 AM

I will address how you can hedge currency “crash” risk (specifically in USDCAD) later in this article, but I find it easier to talk about these strategies from a stock market point of view. Clients not necessarily well versed in derivatives may also find it instructive to learn them in this way.

Bring in…the JPMorgan Hedged Equity Fund

Within the Financial Twitter (“FinTwit”) community there is a widely followed US equity fund managed by JP Morgan Asset Management called The JPMorgan Hedged Equity Fund (fund symbol JHEQX).

The fund seeks exposure to the S&P 500 index and hedges the portfolio systematically (i.e. repeatedly) every quarter via index option contracts on the S&P 500 index.

The easiest way to hedge a portfolio is by purchasing a put option (recall: a long put option gives you the right to sell). However, the problem with systematically purchasing put options is that it becomes expensive over time. Also, recall that the protection a put option offers is down to zero. But what happens if investors don’t need that kind of protection? What are the chances of the S&P 500 going to zero? Very small indeed.

Long Put Option Payoff

Picture1-Jan-19-2022-02-45-45-09-PM

So how do we reduce the cost of purchasing a put option, and also limit the protection it offers?

To do this, the strategy can be converted into a put spread by selling another put option with a lower strike.

Long Put Spread Payoff

Picture3-4

But what if this is still not enough? Systematically purchasing put spreads can also be expensive.

How do we make this structure costless (or “free”)?

Bring in…the Seagull (aka 3-Way or Put Spread Collar)

One way to make this structure costless is to sell a call option against the put spread that you purchased (recall: a short call creates a potential obligation to sell). In other words,

The premium received by selling the call option is the same as the premium paid by purchasing the put spread.

Long Put Spread + Short Call Payoff

Picture4-3

Trade Seagulls to Hedge Large Currency Moves

Now that we’ve introduced the basic mechanics of the structure, how do we implement it in the currency market?

In this case, we assume USDCAD could weaken a lot at some point.

Let’s also assume you’re a Canadian company doing business in US dollars (USD) and have regular USD receivables.  

The Seagull/3-way/Put Spread Collar allows you to:

  • Protect against USD weakness, and
  • Participate in USD strength

How is the strategy constructed?

With USDCAD spot rate around 1.25 we could:

  • BUY 1M 1.22/1.20 put spread 92 DTE (Days To Expiration), and
  • SELL 1M 1.26 call 92 DTE
  • All at even money (i.e. costless)

1.26/1.22/1.20 USDCAD Seagull Payoff

Picture5-1

At expiry in 92 days,

  • If spot fixes above 1.26 → SELL 1M USD at 1.26
  • If spot fixes between 1.22-1.26 → SELL 1M USD at prevailing spot rate
  • If spot fixes below 1.22 → SELL 1M USD at prevailing spot rate PLUS price improvement of cash value of 1.22/1.2 put spread up to (1.22-1.20) x 1M = $20,000 CAD

The Final Lesson

Now, don’t feel overwhelmed if this article feels new or the numbers above don’t make sense right now. We can help you with that.

The purpose of this (and future) articles is convey the interesting currency hedges that can be created to address recurring cash flows that protect against adverse currency moves AND allow you to participate in favorable currency rate movements should they occur.

We can help you construct a currency hedge that appropriately addresses the risk you’re looking to mitigate.

Please call our FX Options Desk in Vancouver, BC at (604) 408-7774, or feel free to email me directly at the email below.

Until next time…

Alex

Alexander Grant, FRM is Olympia Trust CGP’s Head of FX Options Trading. He can be reached at granta@olympiatrust.com if you have questions.

Information provided is for informational purposes only. It is not investment or trading advice, or solicitation for the purchase or sale of any financial instrument.

Topics: Articles

POPULAR

Access over 100 Major and Exotic Currencies

Stay Connected