A Christmas tree spread is a directional options strategy that uses three different strike prices to create an asymmetric risk-reward profile. Named for its shape on a profit/loss diagram, this strategy offers a wider profit zone than a standard butterfly while maintaining limited risk.
What is a Christmas Tree Spread?
A Christmas tree spread is a variation of a butterfly spread where the wings are uneven. Instead of having equal distance between strikes, one side is wider than the other. This creates a directional bias while still benefiting from time decay.
Simple version: Think of a Christmas tree spread as a butterfly that leans to one side. You are betting the stock will move in a specific direction but not too far, similar to a butterfly but with more room for error in your preferred direction.
Call Christmas Tree Structure
A bullish Christmas tree using calls:
- Buy 1 lower strike call (ITM or ATM)
- Sell 1 middle strike call
- Sell 1 higher strike call
- Buy 1 even higher strike call (for protection)
Alternative 3-leg version (also called a ladder):
- Buy 1 lower strike call
- Sell 1 middle strike call
- Sell 1 higher strike call
Call Christmas Tree Example
Stock XYZ is trading at $100. You are moderately bullish, expecting a move to $105-$110.
- Buy 1 $100 call for $4.00
- Sell 1 $105 call for $2.00
- Sell 1 $110 call for $1.00
- Buy 1 $115 call for $0.40
Net debit: $4.00 - $2.00 - $1.00 + $0.40 = $1.40 ($140)
Maximum profit: $3.60 ($360) if stock is at $105 at expiration
Maximum loss: $1.40 ($140) if stock is below $100 at expiration
Upper max loss: $6.40 ($640) if stock is above $115 (without the protective $115 call, loss would be unlimited)
Put Christmas Tree Structure
A bearish Christmas tree using puts:
- Buy 1 higher strike put (ITM or ATM)
- Sell 1 middle strike put
- Sell 1 lower strike put
- Buy 1 even lower strike put (for protection)
Put Christmas Tree Example
Stock XYZ is at $100. You are moderately bearish, expecting a move to $90-$95.
- Buy 1 $100 put for $4.00
- Sell 1 $95 put for $2.00
- Sell 1 $90 put for $1.00
- Buy 1 $85 put for $0.40
Net debit: $1.40 ($140)
Maximum profit: $3.60 ($360) if stock is at $95 at expiration
Maximum loss on upside: $1.40 ($140) if stock above $100
Maximum loss on downside: $6.40 ($640) if stock below $85
Why Use Christmas Tree Spreads?
- Directional bias: Express a bullish or bearish view with defined risk
- Lower cost than verticals: Selling extra options reduces your debit
- Wider profit zone: More forgiving than standard butterflies
- Time decay benefit: Multiple short options decay in your favor
- Higher reward-to-risk: Potential for 2:1 or better return on risk
Profit and Loss Profile
Maximum Profit
Maximum profit occurs when the stock finishes at your first short strike (the middle strike). At this point:
- Your long option has maximum intrinsic value relative to the position
- Your short options are at or near the money
- Time value has decayed from all options
Break-Even Points
Christmas tree spreads have two break-even points:
- Lower break-even: Near your long strike plus the debit paid
- Upper break-even: Depends on the strike configuration
Maximum Loss
Maximum loss on the expected side is limited to your debit paid. Maximum loss on the opposite side (if the stock moves too far past your short strikes) can be larger, which is why many traders add a protective option.
Important: Without the protective wing, Christmas tree spreads have unlimited risk on one side. Always consider adding the protective option, especially on the call side where unlimited risk exists.
Christmas Tree vs Butterfly Spread
- Strike spacing: Butterfly has equal spacing; Christmas tree is uneven
- Directional bias: Butterfly is neutral; Christmas tree has a direction
- Profit zone: Christmas tree has a wider, asymmetric profit zone
- Maximum profit location: Butterfly profits at center strike; Christmas tree profits at first short strike
- Risk profile: Christmas tree has different risk on each side
Christmas Tree vs Vertical Spread
- Cost: Christmas tree costs less due to extra short option
- Profit zone: Christmas tree has wider profit zone
- Max profit: Similar maximum profit potential
- Risk: Christmas tree has asymmetric risk; vertical has symmetric risk
When to Use Christmas Tree Spreads
- Moderate directional view: You expect a move but not a huge one
- High IV environment: You want to sell premium but need protection
- Before known events: When you expect a directional reaction within a range
- When butterflies are too narrow: You want more room for error
- Low capital situations: Cheaper than outright directional plays
Managing Christmas Tree Spreads
Before Expiration
- Stock at target: Consider closing for 50-75% of max profit
- Stock moving away: Set a stop loss at a percentage of your debit
- Stock past short strikes: May need to close to avoid larger losses
At Expiration
- Stock in profit zone: Let options expire or close to avoid assignment risk
- Stock outside profit zone: All options should be closed before expiration
Risks of Christmas Tree Spreads
- Asymmetric risk: One direction has significantly more risk than the other
- Assignment risk: Multiple short options increase early assignment risk
- Complexity: Managing four legs requires attention
- Liquidity: Need liquid options for good fills on all legs
- Pin risk: Multiple short strikes mean multiple pin risk points
Tips for Trading Christmas Tree Spreads
- Always add the protective wing: The small cost is worth the risk reduction
- Choose liquid underlyings: Four legs need tight bid-ask spreads
- Size the position appropriately: Account for the asymmetric max loss
- Know your break-evens: Calculate them before entering
- Set profit targets: Take profits at 50-75% of maximum
- Have a stop loss: Close if the trade goes against you beyond your threshold
Track Your Options Strategies
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Summary
The Christmas tree spread is a directional strategy that offers a wider profit zone than standard butterflies while maintaining defined risk. By using uneven strike spacing, you can express a moderate directional view with favorable risk-reward characteristics. Remember to always add the protective wing to limit your maximum loss and manage the position actively as expiration approaches.
Learn about related strategies: butterfly spreads and vertical spreads.