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This is the fourth installment of our "Real-World Trading" series on the straddle strategy. During the first three weeks, the mock trade we entered on Exxon Mobil (XOM) was working well with the stock falling along with the overall stock market. However, this past week saw strong gains for equities, including XOM, which rose back to a price just below where it was when we started the mock trade. Below is the week-to-week data for the straddle we are following on XOM:

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

Nov. 9, 2009
XOM @ 69.27
1 Jan10 70 call @ 2.70 [IV=22.1]
1 Jan10 70 put @ 3.90 [IV=23.6]
Max Risk = $705
Max Profit = Unlimited
Downside Breakeven = 62.95
Upside Breakeven = 77.05
Current Profit/ Loss = ($45)

Figure 1: Risk Graph of XOM Straddle

XOM shares closed Friday at $66.27, just 31-cents from their price when we entered this mock trade. Implied volatility on the straddle's options also returned to a value very close to where they were when the trade was started. This gives us a very nice example of how time decay impacts a trade. Early in the life of the straddle, time value decreases slowly, which has been the case with this mock trade on XOM. The trade has lost $45, but this is a small amount for a two week time period, especially when compared with the value lost the last month of the options existence. Theta will continue to worsen as time passes, but as of Friday's close, theta for this trade was at $-3.23. Remember, this means all other things staying equal, the trade will lose $3.31 a day from time decay alone. Theta is only 8-cents worse than it was when the trade was opened, showing the small amount of change in theta when expiration is so far away.

Below is a daily stock chart of XOM going back to April. Notice how the daily movement of the stock has created a triangle formation.

Figure 2: Daily Chart of XOM

Another thing to notice is that the stock has rallied sharply heading into the past two earnings announcements and we could be set to see something similar once again. The question is whether the move will be large enough to benefit our straddle strategy. We do not expect IV to drop much lower since it was already at a low level when we entered the trade. This should ease vega risk, which is the risk associated with the decline of IV. When we started the trade, vega was at $30.12 and it now sits at $28.40. This means that all other things being equal, the trade will move $28.40 on a one point move in IV.

If we look at the max risk the trade has the day of XOM's earnings report at the end of the month, we find it near $142. This assumes no change in IV, so this value will adjust as IV changes from day to day. The longer we hold the trade, the more risk we assume because time value will have a larger and larger impact on the value of the trade.

For this trade, we are looking to make a 50 percent profit on the amount put into the trade to start. The debit for this trade was $705, so a profit near $350 is the goal. Considering we are risking just $142, this is a very nice reward-to-risk ratio. This is much better than holding the trade until expiration, when our max risk rises to $705.

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, and make suggestions for what information you would like covered in upcoming articles. I try to cover the things that are important, but this doesn't mean I cover everything that you would like to learn about given a particular strategy.

Jody Osborne
Senior Writer & Options Strategist

Optionetics.com ~ Your Options Education Site

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