Christmas Tree Butterfly With Puts Strategy & Adjustments | Long Put Condor | Management

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In this video we would be learning the Christmas Tree Butterfly with Puts options strategy and would be looking at one possible adjustment that can be made to a troubled position.

Christmas Tree Butterfly Options Strategy:

While the traditional Butterfly spread is a neutral strategy, the Christmas Tree Butterfly spread has a directional bias. It is usually placed slightly above (for the Call variety) or below (for the Put variety) near the money.

It comprises three legs and involves 6 options and is usually established at a net debit.

The Christmas Tree Butterfly spread with Calls has a slight bullish bias and is placed above the underlying asset's price. Conversely, the Christmas Tree Butterfly spread with Puts has a slight bearish bias and is placed below the underlying asset’s price.

In this video, we would limit ourselves to the Put variety.

A Christmas Tree Butterfly spread with Puts strategy is the purchase of one Put at strike price X1, skip strike price X2, the sale of three Puts at strike price X3, and the purchase of two Puts at strike price X4.

It can be seen as simultaneously purchasing one wide Bear Put Spread with strike prices X1 and X3 and selling two narrow Bull Put Spreads with strike prices X3 and X4.

It can also be seen as one long put butterfly spread at X1/X2/X3 overlapped by two long put butterfly spreads at X2/X3/X4.

All the strike prices (X1, X2, X3, X4) are equidistant and the distance between the strike prices X1 and X3 is twice the distance between the strike prices X3 and X4, and all Puts have the same expiration date.

Time decay (Theta) is helpful to the position, while volatility (Vega) is generally unhelpful.

The maximum profit is attained if the underlying is at the strike price X3, that is, at the strike price of the short Puts, at expiration. It is the difference between the strike prices X1 and X3 minus the net debit.

The maximum loss is the net debit of the bought and sold options.

There are two break even points at expiration for this strategy. Lower break even point is between strike prices X1 and X2 and is equal to strike price X1 minus the net debit. Upper break even point is between strike prices X3 and X4 and is equal to strike price X4 plus one half the net debit.

The margin required for this trade is about ₹45-50k and the capital required is about ₹65-70k. Enter the buy option trades first. Capital is defined as the amount of free cash required in your account to enter this trade, while margin is defined as the amount of free cash required in your account to maintain this trade, once you enter it.

Now let’s look at a sample trade:

Nifty is at 10, on June 18, 2020. A Christmas Tree Butterfly with Puts spread can then be entered as follows:

Buy 1 lot of 25th Jun 10000 strike price Put at (X1)
Sell 3 lots of 25th June 9800 strike price Put at (X3)
Buy 2 lots of 25th June 9700 strike price Put at (X4)

Calculations:

Maximum loss at expiry = Net debit = [ - (3 x ) + (2 x )] x 75 = x 75 = ₹1509

Maximum profit at expiry = Difference between the strike prices X1 and X3 - Net debit
= [(10000 - 9800) - ] x 75 = ₹13491

Upper break even point = X1 - Net debit = 10000 - = 9980

Lower break even point = X4 + (Net debit/2) = 9700 + = 9710

Risk graph:

From the risk graph it is clear that though the risk reward ratio is pretty high, the high reward comes with a narrow range. The maximum profit of ₹13491 is attained at the strike price of the sold Puts, that is at 9800 at expiration. The break even points are at 9880 and 9710 and the maximum loss of ₹1509 is achieved when the underlying closes below the lower break even point or above the upper break even point at expiration.

Management:

Say 4 days into the trade, Nifty dropped to 9800.

If you anticipate the index to drop further, construct a reverse Christmas Tree Butterfly with Puts at strike price X3. That is, buy to open two lots of the 25th June 9800 put option, Sell to open three lots of the 25th June 9700 put option and buy to open one lot of the 25th June 9500 put option.

The position would then look like this -

Buy 1 lot of 25th Jun 10000 strike price Put
Sell 1 lot of 25th June 9800 strike price Put
Sell 1 lot of 25th June 9700 strike price Put
Buy 1 lot of 25th June 9500 strike price Put

The aforementioned adjustment would leave us with a Long Put Condor kind of setup. The adjustment would widen the profit range and enhance the probability of profit. But it would increase the risk. The margin and capital required would also come down which is a positive.
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