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This is the third installment of our "Real-World Trading" series on trading a straddle. The first week we dissected the strategy, showing how it works and what to look for when trading this popular strategy. Last week, we chose a stock and entered a mock trade so that we can see how the week-to-week movement of the underlying impacts a straddle strategy. Below is the criterion we used to find an appropriate underlying stock:

1. Find a stock that has low IV compared with historical volatility.
2. Find a stock that has been in a tight trading range.
3. Find a stock that has pending news in the next 4 to 8 weeks.
4. Allow at least 30-days until expiration after the expected news event.
5. Know your breakeven points so that appropriate exit strategies can be set up.

Using this criterion, we found ExxonMobil (XOM) and decided to use this stock for our mock trade. Options on XOM were showing IV near 24.75 percent when IV had been as high at 70 less than a year ago. Last March, XOM IV was still well above 30 and the IV chart shows the mean somewhere near 30 over a two-year period. The stock chart shows XOM in a triangle formation, which often leads to a large move when broken and the company is set to report earnings at the end of October. We expect that these two things will result in an increase in IV, as well as the move needed to achieve a 50 percent profit. Below is the week-to-week data for this mock trade:

Oct. 28, 2009
XOM @ 69.59
Buy 1 Jan10 70 call @ 3.10 [IV=22.7]
Buy 1 Jan10 70 put @ 3.95 [IV=23.7]
Max Risk = $705
Max Profit = Unlimited
Downside Breakeven = 62.95
Upside Breakeven = 77.05
Profit Expectation = $350

Nov. 2, 2009
XOM @ 66.58
1 Jan10 70 call @ 2.00 [IV=24.4]
1 Jan10 70 put @ 5.85 [IV=25.7]
Max Risk = $705
Max Profit = Unlimited
Downside Breakeven = 62.95
Upside Breakeven = 77.05
Current Profit = $80

Figure 1: Risk Graph of XOM Straddle

So far this trade has set up nicely, with XOM shares falling and IV rising. The risk graph above shows that our max loss is at $705 only if we hold the trade until expiration. However, we do not plan on doing this since time decay picks up substantially the last 30-days of an option's life. We actually would sell with about 70-days left, which is shown by the blue line. This line shows that if IV were to stay where it is currently, our max loss is much smaller at just $100. The fact that we are not planning to hold the stock to expiration also means that the breakeven points are not applicable.

Time decay is our greatest risk, but with 105 days until expiration, this is not a huge factor. Theta currently sits at $-3.23, only 4-cents more than last week. This just means that all other things being equal, the trade will lose $3.23 a day from time decay. Obviously, as time passes, theta will become more of a factor. Delta has changed substantially because of the drop in XOM shares. The overall delta of the trade when we entered last week was near zero, but it now is at -26.18. This makes sense seeing that XOM shares have fallen three dollars, or 4.52 percent.

We will be discussing this mock trade until its earnings announcement later this month. Please feel free to ask questions on my forum, which you may access through "Ask the Traders" from the Discussion board on the homepage of Optionetics.com, so that we can all learn from each other. We have some great traders that post on the site and they also provide some great insight about the various trading strategies.

Jody Osborne
Senior Writer & Options Strategist

Optionetics.com ~ Your Options Education Site

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