« Short Christmas Tree with Calls, Puts: Options Trading Strategy »

We introduced a handful of trading picks that utilized a couple of new advanced options trading strategies, in the Options Picks section of our members area, this week. The two new strategies we speak of are the Short Christmas Tree with Calls and the Short Christmas Tree with Puts. In our estimation, current market conditions are perfect for this kind of options strategy and as such we find it a timely inclusion to the strategies that we cover in our Options Picks section.

Now, not all of you might be familiar with the Short Christmas Tree strategy, which can be considered an intermediate to advanced strategy, so here's a primer to help provide a bit of an understanding. A more in-depth study of the strategy will be provided at another time and date (perhaps you've heard of the new Options Theory and Practice classes that we will be launching in the near future).

Short Christmas Tree with Calls:

Short Christmas Tree with CallsThis variant (seen on the right) is constructed using Calls, as the name suggests, and it is a bullish options strategy that also provides the trader with a modicum of safety, in the event the underlying stock actually falls in value.

The strategy is constructed as follows:

Low strike, Short Call: A short position is taken in a call option; most usually, one that is in-the-money.

Middle strike, Long Call: A long position is taken in a call option on a higher strike price; often, one that is at-the-money.

High strike, Long Call: A long position is taken in a call option on an even higher strike; usually, one that is out-of-the-money.

The distance between the first and second strikes and that between the second and the third strikes is typically the same. 

When a trader uses this strategy, he/she is expecting a sharp move in the stock, and his/her strong hunch is that such a move will be to the upside.

Now, you may be wondering if there isn't another slightly less contrived strategy that can be used, such as, say, a Long Strap or a Call Backspread. While you would be right in stating that those strategies are similar, a deeper inspection would shed light on the fact that this strategy provides the benefits of having a short volatility component (on the short leg), which is something the Long Strap does not provide, and of requiring a smaller capital outlay than the Long Strap or the Call Backspread would.

As with all options strategies, the Christmas Tree has a given set of conditions under which it works best. We'll delve further into how you can spot such conditions, in the Options Trading Classes that we will be launching shortly. For now, let's take a brief look at how this strategy works...

In the typical case, a Short Christmas Tree with Calls strategy is constructed such that the underlying stock price is located close to the middle strike or between the middle and the high strike. When the trader is aggressively bullish, the underlying stock price might be situated at a level below the middle strike  or even below the low strike.

Notice that regardless of how the combination is constructed, the goal of the trader's is to see the stock's price rise to a level much higher than the high strike. Failing which, he/she would prefer that the stock be trading below the low strike, because there is often a small loss or even no loss (occasionally, even a profit), if the stock falls below the low strike. So, in a nutshell, the trader wants a sharp move, and preferably one to the upside.

As you might imagine, however, while the trader is willing to be completely wrong on his/her call regarding the direction of the impending move, he/she absolutely does not want the stock to get stuck between the two long call (the middle and the high) strikes, as expiration nears. So, in order to minimize the risk of a big washout, the trader typically looks to close out the position well before expiration, as far as possible.

Short Christmas Tree with Puts:

This variant (seen below) is constructed using Puts, as the name suggests, and it is a bearish options strategy that also provides the trader with a modicum of safety, in the event the underlying stock actually rises in value.

Short Christmas Tree with PutsThe strategy is constructed as follows:

High strike, Short Put: A short position is taken in a put option; most usually, one that is in-the-money.

Middle strike, Long Put: A long position is taken in a put option on a lower strike price; often, one that is at-the-money.

Low strike, Long Put: A long position is taken in a put option on an even lower strike; usually, one that is out-of-the-money.

The distance between the first and second strikes and that between the second and the third strikes is typically the same. 

When a trader uses this strategy, he/she is expecting a sharp move in the stock, and his/her strong hunch is that such a move will be to the downside.

For the most part, the Short Christmas Tree with Puts is the exact opposite (from the point of view of the profit/loss result, in relation to the price level of the underlying stock), so suffice it to say that the trader is looking for decline in the price of the stock; failing which, he/she would prefer that the stock rally past the short put (high) strike. If the stock were instead to be trading in between the two long (low and middle) strikes, as expiration approaches, the result would not be welcome and the trader would most likely want to exit such a position well in advance of expiration.

So, there you have it, that was a brief look at the Short Christmas Tree, options strategy, with Calls and Puts, respectively. We hope that you have found this useful and we look forward to bringing more such options education material to you, in the near future.

Please feel free to leave us any questions you may have via the Comment Form (click the "Post a Comment" link, below, if form is not visible).

Sincerely,

Asher Pinto

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Comments

[smith]

Short Christmas tree with puts and short Christmas tree with calls are the two vital tools which are now a days being used in the options trading. It is a new information and is a new strategy for the options trading.