WHAT IS CHRISTMAS TREE SPREAD WITH PUTS STRATEGIES?

 

   A Christmas Tree Spread with Puts is a complex options strategy that involves using put options to profit from minimal price movement in the underlying asset while limiting potential losses. This strategy is particularly popular when an investor believes that a stock's price will move slightly lower but wants to minimize risk in case the price falls significantly or rallies unexpectedly. The Christmas Tree Spread gets its name due to the pattern formed by the different strike prices on a payoff diagram, which somewhat resembles the shape of a Christmas tree.

 

Key concepts in options before understanding the strategy

 

To grasp the Christmas Tree Spread with Puts, let’s first understand some key options concepts:

 

Put options:  A put option gives the holder the right, but not the obligation, to sell an underlying asset at a specific price (strike price) before or on a certain expiration date.

 

Strike price:  This is the predetermined price at which the underlying asset can be bought or sold when the option is exercised.

 

Premium:  This is the price that the buyer of the option pays to the seller (also called the writer) to obtain the right that the option confers.

 

Expiration date:  The last day that the option is valid.

 

Vertical spread:  This involves buying and selling two options of the same type (calls or puts) on the same underlying asset but with different strike prices.

 

Ratio spread:  This involves buying and selling a different number of options with varying strike prices. For instance, selling multiple puts while buying a smaller number of puts.

 

Understanding the christmas tree spread with puts

 

   The Christmas Tree Spread with Puts is a modified version of a ratio spread. It is composed of multiple put options with different strike prices, and the construction of this strategy varies depending on the investor’s risk appetite and market expectations. Typically, you will buy one or two put options and sell more put options at different strike prices.

 

The christmas tree spread consists of:

 

Buying 1 put at a higher strike price (ATM or slightly OTM),

Selling 2 puts at a lower strike price,

Selling 1 put at an even lower strike price.

In this configuration, you’re creating a defined-risk, limited-reward strategy that profits most when the underlying asset stays within a narrow price range.

 

Steps to construct a christmas tree spread with puts

 

Let’s break down how the Christmas Tree Spread with Puts is constructed step-by-step:

 

Choose a stock or underlying asset:  First, select a stock or underlying asset on which you wish to create this options strategy. You should ideally have a neutral-to-bearish outlook on the stock.

 

Buy a put option (ITM or ATM):  The first step is buying one put option at or near the current price of the underlying stock. For example, if a stock is trading at Rs.100, you might buy a Rs.100 strike put option.

 

Sell two put options at a lower strike price:  Next, you sell two put options at a lower strike price, such as Rs.95. This creates a ratio spread. The goal is to collect more premium from selling these options than what you spent on buying the initial put.

 

Sell one more put option at an even lower strike price:  Finally, you sell another put option at a still lower strike price, such as Rs.90. This lowers the overall cost of the trade but limits your potential profits and increases risk.

 

Set the expiration date:  Make sure that all the options involved expire on the same date.

 

Example of a Christmas Tree Spread with Puts

Let’s walk through a hypothetical example to make the concept clear.

 

Imagine XYZ stock is currently trading at Rs.100, and you believe it will slightly decline in price but not collapse. To create a Christmas Tree Spread with Puts, you decide to:

 

Buy 1 put at the Rs.100 strike price for Rs.5 (this costs you Rs.500, as each option contract represents 100 shares).

Sell 2 puts at the Rs.95 strike price for Rs.3 each (this gives you Rs.600, as you are selling two contracts).

Sell 1 put at the Rs.90 strike price for Rs.1.5 (this gives you Rs.150).

Net Cost or Premium

Now, let’s calculate the total cost of setting up this trade.

 

You pay Rs.500 to buy the first put.

You receive Rs.600 from selling two Rs.95 strike puts.

You receive another Rs.150 from selling the Rs.90 strike put.

The total premium received is Rs.750, and since you spent Rs.500, your net credit is Rs.250. This means that you are getting paid Rs.250 to initiate the Christmas Tree Spread with Puts.

 

Payoff at expiration

 

Let’s look at how this strategy would perform at different stock prices at expiration.

 

If XYZ finishes at Rs.100 or higher:  All the put options expire worthless since the stock is at or above the strike prices. You get to keep the net credit of Rs.250 as your profit.

 

If XYZ finishes at Rs.95:  The Rs.100 put you bought would be worth Rs.500 (since it’s Rs.5 ITM), and the two Rs.95 puts you sold would expire worthless. You would have no further obligations, and your profit would be the Rs.500 from the Rs.100 put plus the Rs.250 net credit, totaling Rs.750.

 

If XYZ finishes at Rs.90:  The Rs.100 put would be worth Rs.1,000 (since it’s Rs.10 ITM), but the two Rs.95 puts you sold would be worth Rs.500 each (since they’re Rs.5 ITM). The put you sold at Rs.90 would expire worthless. Here’s how the math works:

 

Rs.1000 from the Rs.100 put,

You owe Rs.1,000 on the two Rs.95 puts,

The net result is Rs.0, but you still keep the Rs.250 credit from the initial setup, so your profit is Rs.250.

 

If XYZ finishes below Rs.90:  The risk of the Christmas Tree Spread with Puts increases if the stock drops below Rs.90. Your Rs.100 put would be worth Rs.1,000, and the two Rs.95 puts would be worth Rs.500 each. However, the Rs.90 put you sold would now be ITM and cost you money.

 

If the stock drops to Rs.85, for example:

 

The Rs.100 put is worth Rs.1,500,

The two Rs.95 puts cost you Rs.1,000,

The Rs.90 put you sold costs you Rs.500,

Your profit would be Rs.1,500 – Rs.1,000 – Rs.500 = Rs.0, and you still keep the Rs.250 initial credit.

If the stock falls further, below Rs.85, you start incurring losses.

 

Advantages of christmas tree spread with puts

 

Limited risk:  This strategy has a defined risk. Even in a worst-case scenario, your maximum loss is capped.

Reduced cost:  The premiums received from selling options offset the cost of buying the initial put, making this a relatively inexpensive strategy to initiate.

Profit in range-bound market:  The strategy works well if the stock remains range-bound or declines slightly.

 

Disadvantages of christmas tree spread with puts

 

Complex setup:  This is not a beginner-friendly strategy. It requires multiple options at different strike prices, and managing the trade can be complex.

Limited reward:  The profit potential is capped at certain price levels, so this strategy is not ideal for traders looking for unlimited upside.

Margin requirements:  Selling multiple puts may require substantial margin, which can limit the accessibility of this strategy for some traders.

 

Conclusion

 

   The Christmas Tree Spread with Puts is an intricate strategy that suits experienced options traders with a neutral to slightly bearish outlook on a stock. It offers limited risk and potential for a moderate profit if the underlying stock price stays within a narrow range. However, like any options strategy, it requires a thorough understanding of strike prices, expiration dates, and market behavior. This strategy is particularly useful when a trader believes that significant price drops are unlikely but wants to hedge against moderate downside movement.