Christmas Tree Butterfly w/Puts

The Strategy

You can think of this strategy as simultaneously buying one long put spread with strikes D and B and selling two short put spreads with strikes B and A. Because the long put spread skips over strike C, the distance between its strikes will be twice as wide as the strikes in the short put spread. In other words, if the width from strike D to strike B is 5.00, the width from strike B to strike A will be 2.50.

While a traditional butterfly with puts is often used as a neutral strategy, this strategy is usually run with a slightly bearish directional bias. To reach the sweet spot, the stock price needs to drop a bit.

Selling two short put spreads with half the width of the long put spread usually makes this strategy less expensive to run than a traditional butterfly with puts. The tradeoff is that you’re taking on more risk than you would with a traditional butterfly. If the stock continues to fall below strike B, your profit will decline at an accelerated rate and the trade could become a loser fairly quickly. That’s because you’re short two put spreads, and there’s half as much distance between strike B and strike A (short spreads) as there is between strike D and strike B (long spread).

Ideally, you want the options at strike A and B to expire worthless, while retaining maximum value for the long put at strike D.

The Setup

• Buy a put, strike price D
• Skip over strike price C
• Sell three puts, strike price B
• Buy two puts, strike price A
• Generally, the stock will be at or around strike D

NOTE: Strike prices are equidistant, and all options have the same expiration month.

Who Should Run It

Seasoned Veterans and higher

Break-even at Expiration

There are two break-even points for this strategy:

• Strike D minus the net debit paid
• Strike A plus half the net debit paid

The Sweet Spot

You want the stock to be exactly at strike B at expiration.

Maximum Potential Profit

Potential profit is limited to strike D minus strike B minus the net debit paid.

Maximum Potential Loss

Risk is limited to the net debit paid.

Margin Requirement

After the trade is paid for, no additional margin is required.

As Time Goes By

For this strategy, time decay is your friend. Ideally, you want all of the options except the put with strike D to expire worthless.

Implied Volatility

After the strategy is established, the effect of implied volatility depends on where the stock is relative to your strike prices.

If the stock is at or near strike B, you want volatility to decrease. Your main concern is the three options you sold. A decrease in implied volatility will cause those near-the-money options to decrease in value, thereby increasing the overall value of the butterfly. In addition, you want the stock price to remain stable around strike B, and a decrease in implied volatility suggests that may be the case.

If the stock price is approaching or outside strike D or A, in general you want volatility to increase. An increase in volatility will increase the value of the option you own at the near-the-money strike, while having less effect on the short options at strike B.