In the above example:
- Buy 1 Call strike 95
- Sell 3 Calls strike 105
- Buy 2 Calls strike 110
The position is established for a net debit, and both the potential profit and maximum risk are limited.
Strike prices are equidistant, and all options have the same expiration month.
Risk is limited to the net debit paid: after the trade is paid for, no additional margin is required.
Bullish or bearish strategy
The strategy might be bullish or bearish depending where the price of the security is compared to the strike prices.
The lower the stock price is below strike price 95 when you initiate the strategy, the more bullish this strategy becomes. The benefit is that it will cost less to establish, which means your maximum potential loss will be lower. However, the stock will need to make a bigger move to hit the sweet spot.
If the stock price is above the strike price 110, then the strategy is bearish, and the higher the stock price the lower the overall cost to open the position; also in this case this means a higher potential profit and a lower loss, but also in this case you need the stock to move considerably.
Like the Christmas Tree with Puts, also the Christmas Tree with Calls may be an affordable alternative to long calls or puts when calls or puts are prohibitively expensive because of high implied volatility.
Ater 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 105, you want volatility to decrease, which will cause the options that you sold to decrease in value, thereby increasing the overall value of the butterfly. In addition, you want the stock price to remain stable around strike 105, and a decrease in implied volatility suggests that may be the case.
If the stock price is approaching or outside strike 95 or 110, in general you want volatility to increase, which will increase the value of the options you own, while having less effect on the short options at strike 105.