Christmas Tree Butterfly w/Puts

Christmas tree spread put - Options Playbook

The setup

Buy a put, strike price D
Skip over strike price C
Sell three puts, strike price B
Buy two puts, strike price A
Generally, the stock will be at or around strike D

The strategy

You can think of this strategy as simultaneously buying one long put spread with strikes D and B and selling two short put spreads with strikes B and A. Because the long put spread skips over strike C, the distance between its strikes will be twice as wide as the strikes in the short put spread. In other words, if the width from strike D to strike B is 5.00, the width from strike B to strike A will be 2.50.

While a traditional butterfly with puts is often used as a neutral strategy, this strategy is usually run with a slightly bearish directional bias. To reach the sweet spot, the stock price needs to drop a bit.

Selling two short put spreads with half the width of the long put spread usually makes this strategy less expensive to run than a traditional butterfly with puts. The tradeoff is that you’re taking on more risk than you would with a traditional butterfly. If the stock continues to fall below strike B, your profit will decline at an accelerated rate and the trade could become a loser fairly quickly. That’s because you’re short two put spreads, and there’s half as much distance between strike Band strike A (short spreads) as there is between strike D and strike B (long spread).

Ideally, you want the options at strike A and B to expire worthless, while retaining maximum value for the long put at strike D.

Options guys tips

The higher the stock price is above strike price D when you initiate the strategy, the more bearish this strategy becomes. The benefit is that it will cost less to establish, which means your maximum potential loss will be lower. However, the stock will need to make a bigger move to hit the sweet spot.

Because of the bearish bias on this strategy, it may be an affordable alternative to a long put when puts are prohibitively expensive because of high implied volatility. This is especially the case if you’re anticipating a decrease in volatility after a bearish move. Whereas a long put owner wants implied volatility to increase, you’ll want to see a decrease in implied volatility after this strategy is established.

Who should run it

Seasoned Veterans and higher

When to run it

You’re slightly bearish. You want the stock to fall to strike B and then stop.

Break-even at expiration

There are two break-even points for this strategy:

Strike D minus the net debit paid
Strike A plus half the net debit paid

The sweet spot

You want the stock to be exactly at strike B at expiration.

Maximum potential profit

Potential profit is limited to strike D minus strike B minus the net debit paid.

Maximum potential loss

Risk is limited to the net debit paid.

Margin requirement

After the trade is paid for, no additional margin is required.

As time goes by

For this strategy, time decay is your friend. Ideally, you want all of the options except the put with strike D to expire worthless.

Implied volatility

After the strategy is established, the effect of implied volatility depends on where the stock is relative to your strike prices.

If the stock is at or near strike B, you want volatility to decrease. Your main concern is the three options you sold. A decrease in implied volatility will cause those near-the-money options to decrease in value, thereby increasing the overall value of the butterfly. In addition, you want the stock price to remain stable around strike B, and a decrease in implied volatility suggests that maybe the case.

If the stock price is approaching or outside strike D or A, in general you want volatility to increase. An increase in volatility will increase the value of the option you own at the near-the-money strike, while having less effect on the short options at strike B.

When running a calendar spread with calls, you’re selling and buying a call with the same strike price, but the call you buy will have a later expiration date than the call you sell. You’re taking advantage of accelerating time decay on the front-month (shorter-term) call as expiration approaches...