An advanced options strategy that has three legs and a total of six options is called a Christmas tree spread with puts. Buying one put at strike price D, bypassing strike price C, selling three puts at strike price B, and then buying two puts at strike price A are the steps in the option strategy. Similar to a butterfly spread, but with more room for the stock price to fall, making it a more bearish option strategy, the desired result is a pin at the short middle strikes.
Additionally, costs are higher compared to a typical butterfly spread since the long upper legged strike price is farther from the short middle strikes. The stock must decrease in price in order for the position to become profitable 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 highest strike price and the three short middle put strike prices is used to determine the maximum profit, which is then subtracted from the trade’s cost. For instance, the maximum profit would be Rs 7.50 if the distance between point D and point B was Rs 10 and the deal cost Rs 2.50.
With the identical scenario, the maximum loss would be Rs 2.50 since the cost of the deal would be the maximum loss.
Breakeven
There are two points where things break even. By deducting the cost of the deal from the top strike price (point D), the upper breakeven point can be determined. Therefore, if trading cost Rs 2.50 and point D was an option with a strike price of 110, the upper breakeven would be Rs 107.50.
The lowest strike price (point A) plus one-half of the net debit would be used to determine the lower breakeven point. Therefore, if the cost of the trade was Rs 2.50 and the point A strike price was Rs 95 the lower breakeven would be Rs 96.25 (95 + 2.50 / 2).
Example
A trader might execute a 110/100/95 Christmas tree spread by purchasing one put with a strike price of 110, selling three puts with a strike price of 100, and purchasing two puts with a strike price of 95 for the following prices:
- For Rs 8, purchase 1 XYZ 110-strike price put.
- Sell three XYZ puts with a 100 strike price for Rs 6.90 (Rs 2.30 apiece).
- Invest Rs 1.40 (Rs .70 per) to purchase two XYZ 95-strike price puts.
- Total expense: Rs 2.50
The investor will have lost the whole Rs 2.50 and all holdings will be eliminated from his account if the stock increases in value over the ensuing three months.
The trader will profit Rs 10 on the market movement and the 110-strike price option if the stock goes down to Rs 100 at expiration, while the remaining options expire worthless. Their net profit would be Rs 7.50 because they spent Rs 2.50 to make the trade.
The investor would profit Rs 20 on the Rs 110 put if the stock fell to Rs 90. The short middle 100-puts lose Rs 10 X 3 for a total loss of Rs 30. Gain Rs 5 twice for a total of Rs 10 on the long lower 95-puts.
The investor paid Rs 2.50 for the trade, therefore their net loss is Rs 2.50. The final result would be Rs 20 – Rs 30 + Rs 10, meaning all profits are lost.
Conclusion
The more bearish a Christmas tree spread grows, while also lowering the cost of the deal, the lower a trader sets the strike prices. However, the likelihood of success decreases when strike prices are lowered.
The implied volatility is sensitive to variations 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 would decrease.
Only seasoned traders should implement a Christmas tree spread options strategy; it is not advised for beginners.
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