When we construct strangles instead of straddles in a similar manner we have done for Ratio Spread i.e. to mimic strangles but limits the risk or the reward in one direction, the strategy is called Christmas Tree.
It is also known as ladders.
Let’s discuss the Long Put Christmas Tree setup with a live example and study the effect of Break Even points during various DTEs.
The payoff graph looks like –
So, Our Lower Breakeven point in this strategy is 16300. It means if it stays above 16300 on expiry day, We will not be in loss.
Let’s talk about the Lower BEP of what happens to it on the next trading day?
However, note that “DTE” is an acronym for Days to Expiry.
So, as long as the BankNIFTY index doesn’t fall steadily more than that %, the unrealized losses will not pop up. It is unusual to fall like this as anyways the breakeven point of 16300 where actual realized loss may happen is nearly 18.5% from the current point.
But, last week, BN fell 18.5% in the Friday itself shooting unrealized loss off the charts! Now, as we have seen how the unrealized loss works here. We shift to the next question – “Do we get a huge profit if a sudden downside move happens?”
Let’s see the pay off graph each day assuming the IV stays the same! The above image is the payoff graph of Friday.
Saturday (The market is closed so we can skip thinking about this)
Sunday (The market is closed so we can skip thinking about this)
When we take the trade, the loss is happening when we breach the BEP on Thursday but in this case, we are studying unrealized losses in previous days. Like, If BankNIFTY doesn’t break 17800 this position will show a profit on Monday.
But, this spread has more options sold (-gamma,+theta,-vega) than bought so the effect of movement of underlying affects very badly when the effect of Theta hasn’t kicked in prominently.
We can see the effect of Theta here. There is a sudden jump in the profits as well as the breakeven points. This is non symmetrical.
Till before today, the options payoff was almost the same as the payoff of short straddle over various DTEs. So, when constructing this type of Long Christmas Trees. (It is called the Long Put Christmas Tree because it has unlimited loss towards the downside. It has nothing to do with credit or debit as it will always be credit spread).
However, if the strategy is executed near expiry, it will be a debit spread as the impact of theta and vega is more on the OTM strike prices as they have more extrinsic value. So, if it is executed near DTE, change in IV and change in spot will positively impact the payoff.
In fact, we can also buy more OTM options with the premium received from ATM options. Anyways, this is the final payoff graph that happens on Wednesday. (The expiry is on Wednesday in case of this contract.)
A movement towards the downside will give maximum profit. But, as said, the more it is near to DTE, the better the chances of profit maximization.