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We are in week five of our Real-World series on trading a straddle. At the end of September, we decided to follow a straddle to show how this delta neutral strategy works. In review, a straddle is the combination of a long put and long call using the same strike and same expiration. This might seem like a contradiction, but when using options, we can profit from large moves in either direction using this strategy.

The key with a straddle is finding a stock that is set to move sharply, though the direction is not known. We also want to use options that are showing low IV compared to the past six months of readings. Since we are buying both calls and puts, IV can have a huge impact on the value of the trade. Even if the underlying moves sharply, if IV plummets, a loss could still develop. Another risk is time decay, especially the last 30-days of the option contracts. To offset these risks, we look for low IV options and use longer term options so that theta decay will not be a huge impact on the trade.

Back in late September, we chose to use ExxonMobil (XOM) in our mock trade. At the time, IV was low compared with the recent six months and the stock was set to announce earnings at the end of month, which has resulted in nice moves in the stock. We also liked the setup on the daily chart of XOM, which was showing a triangle formation. Below is the week-to-week data for this mock trade, as well as risk graph as of trading on Friday, Oct. 16.

Sept. 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

Oct. 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

Oct. 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)

Oct. 16, 2009
XOM @ 73.12
1 Jan10 70 call @ 4.53 [IV=20.3]
1 Jan10 70 put @ 1.84 [IV=21.6]
Max Risk = $705
Max Profit = Unlimited
Downside Breakeven = 62.95
Upside Breakeven = 77.05
Current Profit/Loss = ($68)

Figure 1: Risk Graph of XOM Straddle

We can see that XOM shares broke above this triangle formation this past week, yet the trade itself is showing a minor loss at the moment.This is loss has been a result of lower IV, which is down about 16 percent in the past two weeks and down 10 percent since we started the trade. This shows us how important it is to find options that are near the low end of their recent IV values. There is nothing that guarantees that IV won't fall lower, but if we entered XOM options when IV was near 40, it would have been virtually impossible to see profits given the sharp drop in IV the past few months.

Now that XOM has broken through its triangle formation, we could see the stock continue to rise. There also is the possibility that the stock will retest this break before moving higher. Earnings are set for Oct. 29 and this event is likely to help push IV highe as we approach the announcement. If we do not see a move following this event, than it is time to exit the trade at whatever profit/loss there is and move on. The idea is that since we own a call and a put, our loss will be minimal as long as we get out before the options have 45-days or less until expiration.

The volatility XOM has shown is a great example of why adjustments are made by many delta neutral traders, but this is a discussion for a different day. We will continue to follow this trade through the earnings announcement to show how a straddle is impacted by news and changes in IV. In the meantime, please feel free to ask questions or make comments on my forum, which you may access through "Ask the Traders" from the Discussion board on the homepage of Optionetics.com, so we can all learn together.

Jody Osborne
Senior Writer & Options Strategist

Optionetics.com ~ Your Options Education Site

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