Christmas Tree Spread. The option strategy entails purchasing one call at strike price A, skipping strike price B, selling three calls at strike price C, and finally purchasing two calls at strike price D. It is somewhat akin to a butterfly spread in that a pin at the short middle strikes is the desired result, but there is more room to run on the upside, making it a more bullish option strategy.
Due to the long lower legged strike price being further away from the short middle strikes than the standard butterfly spread, costs are also higher. The stock must rise in price in order for the position to turn a profit because it was opened at a higher cost. Losses are capped at the opening price in the event that the stock moves against the trader, even though the likelihood of a loss is higher.
Profit/Loss
The difference between the lowest strike price and the three short middle call strike prices is subtracted from the cost of the trade to determine the maximum profit. For instance, the maximum profit would be Rs7.50 if the distance between points A and C was Rs10 and the trade cost Rs2.50.
In the same example, the maximum loss would be Rs2.50 because it would equal the cost of the trade.
Breakeven
There are two points where things break even. By taking the bottom strike price (point A) and adding the trade’s cost, one can determine the lower breakeven point. Therefore, the lower breakeven would be Rs92.50 if point A was a 90-strike price option and the trade cost Rs2.50.
The highest strike price (point D) would be used to determine the upper breakeven point, from which one-half of the net debit would be subtracted. Therefore, if the trade’s cost was Rs2.50 and the point D strike price was equal to Rs105, our upper breakeven would be 103.75 (105-2.50/2).
Example
A trader could execute a 90/100/105 Christmas tree spread by purchasing one call with a strike price of 90, selling three calls with a strike price of 100, and purchasing two calls with a strike price of 105 for the following prices:
- Buy 1 XYZ 90-strike price call for Rs8.00
- Sell 3 XYZ 100-strike price calls for Rs6.90 (Rs2.30 each)
- Buy 2 XYZ 105-strike price calls for Rs1.40 (Rs.70 each)
- Total cost = Rs2.50
The investor will have lost the full Rs2.50 if the stock declines over the following three months, and all positions will be eliminated from his account.
The trader will profit Rs10 from the stock movement, taking advantage of the 90-strike price option, while the other options expire worthless if the stock trades up to Rs100 at expiration. Their net profit would be Rs7.50 because they spent Rs2.50 to make the trade.
The investor would have made Rs20 on the Rs90 call if the stock had reached a price of Rs110. Spend Rs30 in losses on the short middle 100-calls, or Rs10 X 3. Gain Rs5 twice for a total of Rs10 on the long upper 105-calls.
The investor would have paid Rs2.50 for the trade, so their net loss would only be Rs2.50. The final result would be Rs20 – Rs30 + Rs10, meaning all profits are a wash.
Conclusion
The more bullish a Christmas Tree spread becomes, while also lowering the cost of the trade, the higher the trader sets the strike prices. However, the likelihood of success decreases as strike prices are raised.
The implied volatility is sensitive to changes in this kind of spread. Inversely correlated with changes in implied volatility is the spread’s net price, which decreases when implied volatility increases and rises when implied volatility decreases. The trader who places this order hopes implied volatility will decrease.
Only seasoned traders should use a Christmas tree spread options strategy; it is not a strategy for beginners.
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