Christmas Tree Spread: Options Strategy Guide

The Christmas Tree Spread is a unique options strategy that gets its festive name from its payoff diagram, which resembles a Christmas tree when drawn. This advanced strategy uses multiple strikes at progressively different quantities to create an asymmetric profit profile. It is essentially a modified ratio spread that offers defined risk while targeting moderate directional moves. This guide will teach you how to construct and trade Christmas Tree Spreads effectively.

What is a Christmas Tree Spread?

A Christmas Tree Spread is a multi-leg options strategy that combines elements of vertical spreads and ratio spreads. The classic structure uses three different strikes with a 1:3:2 ratio of contracts. When plotted, the payoff diagram fans out like a tree, wider at the base and narrowing to a point at the top.

Structure of the Christmas Tree

The classic Christmas Tree uses calls for bullish plays and puts for bearish plays:

Bullish Christmas Tree (Calls)

• Buy 1 at-the-money or near-the-money call
• Sell 3 out-of-the-money calls (at a higher strike)
• Buy 2 further out-of-the-money calls (at an even higher strike)

Bearish Christmas Tree (Puts)

• Buy 1 at-the-money or near-the-money put
• Sell 3 out-of-the-money puts (at a lower strike)
• Buy 2 further out-of-the-money puts (at an even lower strike)

Understanding the Payoff Profile

Maximum Profit

Maximum profit occurs when the stock closes at your short strikes at expiration:

• Using our example, if stock is at $110:
• $100 call worth $10.00
• $110 calls expire worthless
• $115 calls expire worthless
• Profit: $10.00 - $0.75 debit = $9.25 ($925 per structure)

Downside Risk

If stock stays at or below $100:

• All options expire worthless
• Loss: $0.75 debit paid ($75 per structure)
• This is your maximum loss on the downside

Upside Risk

If stock rallies past $115:

• You are long 1 call at $100
• Short 3 calls at $110
• Long 2 calls at $115
• Net position above $115: -1 call (1-3+2 = 0, but spread creates locked loss)
• The structure creates a defined loss zone between $110 and $115

Let us calculate the exact upside risk. Above $115:

• $100 call profit: Stock price - $100
• $110 calls loss: 3 x (Stock price - $110)
• $115 calls profit: 2 x (Stock price - $115)
• At any price above $115, these offset for a fixed value
• Maximum loss on upside: Approximately $5.75 ($575 per structure)

Alternative Christmas Tree Structures

1:2:1 Christmas Tree

A simpler version with fewer contracts:

• Buy 1 ATM call
• Sell 2 OTM calls
• Buy 1 further OTM call

This is essentially a broken wing butterfly and is easier to manage.

Ratio Christmas Tree

For more aggressive premium collection:

• Buy 1 ATM call
• Sell 4 OTM calls
• Buy 3 further OTM calls

This collects more premium but has more complex risk.

When to Use Christmas Tree Spreads

This strategy works best in specific conditions:

• Moderate directional conviction: You expect a move but not a massive one
• Specific price target: You have a defined target in mind
• High implied volatility: Elevated IV makes the spread cheaper or provides credit
• After large moves: When you expect mean reversion to a specific level
• Pre-earnings: Targeting a specific post-earnings price (advanced)

Advantages of Christmas Tree Spreads

• Defined risk both sides: Unlike ratio spreads, risk is capped
• Low capital requirement: Can be entered for small debit or credit
• High profit potential: Can return 10:1 or more at target
• Flexible structure: Can be adjusted with different ratios
• Works in high IV: Benefits from selling multiple options

Risks and Disadvantages

• Complex structure: Multiple legs require careful execution
• Narrow profit zone: Stock must settle near short strikes
• Commission heavy: Six contracts (in classic structure) means higher costs
• Difficult to adjust: Rolling multiple legs is complicated
• Liquidity requirements: Needs liquid options for good fills

Managing Christmas Tree Positions

Taking Profits

Because the maximum profit zone is narrow:

• Consider taking profits at 30-50% of maximum
• Do not wait for expiration - time decay is not always your friend
• Set a profit target when entering the trade

Cutting Losses

If the trade moves against you:

• Set a maximum loss threshold (e.g., 2x the debit paid)
• Close early if the stock moves strongly in the wrong direction
• Do not try to roll a losing Christmas Tree - close and reassess

Near Expiration

As expiration approaches:

• Close if near the short strikes to avoid assignment risk
• Let expire if well away from all strikes
• Watch for pin risk around the short strikes

Christmas Tree vs Other Strategies

Tips for Success

• Start with the 1:2:1 version: Simpler to understand and manage
• Use liquid underlyings: SPY, QQQ, and major stocks only
• Calculate max risk: Know your worst-case scenario before entering
• Set price targets: Have a specific stock price in mind
• Trade small: These are complex - start with one structure
• Avoid earnings: The narrow profit zone makes earnings risky

Summary

The Christmas Tree Spread is an advanced options strategy that offers defined risk while targeting moderate directional moves to a specific price. By using a ratio structure with protective wings, you can create asymmetric payoffs with high profit potential and limited downside. The strategy works best in high IV environments when you have a specific price target. While complex to execute and manage, the Christmas Tree can be a powerful tool for sophisticated options traders looking to express precise market views.

Want to explore related strategies? Check out our ladder spread guide or learn about broken wing butterflies.