Now’s the Time for a Christmas Tree Spread

by Lawrence Meyers | December 19, 2012 8:45 am

I was trying to think of a great options strategy for Christmas, one that would yield massive premiums that you could go buy a new car with. However, I covered that topic recently[1] from a slightly different angle.

But wouldn’t you know it, there’s actually an option trade called the Christmas Tree Spread, and there are some great ways to apply it right now. Let’s take a look.

The Christmas Tree is very similar to the Butterfly Spread strategy[2]. Both combine a debit (bull) call spread and a credit (bear) call spread sold at a higher strike price. Both spreads are based on the same idea about the market, namely, that you expect volatility will decrease and the underlying stock will remain in a tight range.

But — and it’s big but — in the Christmas Tree Spread, the distance between the strike prices of the debit spread and the credit spread are not equal. The trade’s debit spread will have larger distance between the strike prices than the credit spread. Thus, to compensate, you sell more contracts of the credit spread.

The scenario is ideal if you have a slightly bearish or bullish expectation on a given stock.

Let’s look at a real-world example that I think this strategy is perfect for: J.C. Penney (NYSE:JCP[3]). The company is going through a turnaround right now, and nobody is certain how its holiday season sales are going to perform. So if you hold the stock, which I do, it’s a great way to hedge.

As of this writing, JCP is trading at $20.21. We want to look at the strikes from $17.50 to $21.

First, let’s take a look at the debit (bull) spread side of the trade. First, buy the in-the-money option — the January 17.5 call — for $3.20, and sell the at-the-money option, the January 20 call, for $1.65. This transaction costs you $1.55.

Now, we do the credit (bear) spread side of the trade. Sell two January 20 calls for $1.65, and buy two January 21 calls for $1.15. You’ll have a net credit of $1.

When you put them all together, you end up buying one 17.5 call, selling three 20 calls, and buying two 21 calls. Your net debit is 55 cents.

You receive maximum profit if the stock finishes at $20 because the debit spread pays off in full and the credit spreads expire. At $20, you make $2.50 on the 17.5 call, while the $20 and $21 calls expire worthless. You got dinged 55 cents to execute the trade, so your net profit is $1.95.

Note that the gains from your debit spread exactly offset losses on the credit spread. The most you can lose is the cost of the debit, or 55 cents. If the stock stays between $18.05 and $20.95, you’ll make a profit.

Two other places to look at using this strategy are with Best Buy (NYSE:BBY[4]) and gold, via the SPDR Gold Shares (NYSE:GLD[5]). Best Buy is a total crapshoot as a company these days, and gold is always volatile.

As of this writing, Lawrence Meyers[6] was long JCP. He is president of PDL Capital, Inc.[7], which brokers secure high-yield investments to the general public and private equity. He also has written two books[8] and blogs about public policy[9], journalistic integrity[10], popular culture[11] and world affairs[12].

  1. I covered that topic recently:
  2. Butterfly Spread strategy:
  3. JCP:
  4. BBY:
  5. GLD:
  6. Lawrence Meyers:
  7. PDL Capital, Inc.:
  8. written two books:
  9. public policy:
  10. journalistic integrity:
  11. popular culture:
  12. world affairs:

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