Ultimate Guide To Christmas Tree With Calls

Introduction

When an investor is long a call, he expects the stock price to rise above the strike price before the expiration.

A call gives him a maximum gain of infinity; however, any experienced investor realizes that there is no value to holding infinity.

Therefore, he enters a call spread by selling another call at a higher strike price to recoup some of the premium paid for the initial call.

There are two drawbacks to consider while using a call spread:

  • Selling a call at a higher strike price will not generate enough premium to offset the initial long call so the investor still ends up with a large net debit position.
  • By selling a call, the investor is selling infinity to someone else. What if the stock breaks all resistance and rallies above the strike of the sold call?

A Christmas tree with calls partially alleviates some of these drawbacks.

A Christmas tree with calls is a three-legged strategy involving six calls. The investor starts with a long call at strike A, skips strike B, sells 3 calls at strike C, and buys 2 calls at strike D.

Note, only the strikes differ. All options share the same underlying and same expiration.

Let’s look at an example of Uber. The investor is long a call with a strike of $37.5, sells 3 calls at a strike of $38.5, and buys 2 calls at a strike of $39.

Before we look at the payoff of a Christmas tree with calls, let’s understand that this strategy will usually result in a small net debit i.e. the investor has to pay to enter the strategy.

In the uber example, the net debit is calculated as follows:

Compare this with the net debit of a regular call spread:

By selling additional calls, the investor recoups more premium to offset the cost of the initial call.

And by buying additional calls, the investor flatlines the payoff diagram so he is not exposed to further downside.

Maximum Loss

The investor is long 3 calls and short 3 calls. The most he can lose is the net debit paid.

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Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are ...

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