We are in week six of our Real-World Trading series on using a straddle. This particular strategy is used when a stock's options are showing low IV and we expect a large move in either direction. Though a straddle can seem counterintuitive, this strategy can indeed bring profits to traders.

We chose to use ExxonMobil (XOM) in our mock trade to see how upcoming earnings and a triangle formation would impact a straddle. We have seen a lot of movement in XOM shares, but the move hasn't been large enough to provide the profits we would like to see. XOM is set to report earnings on Thursday, which means we need to discuss exit strategies. Below we have the data from week to week for this mock trade:

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)

Oct. 23, 2009
XOM @ 73.57
1 Jan10 70 call @ 5.18 [IV=23.8]
1 Jan10 70 put @ 2.01 [IV=25.0]
Max Risk = $705
Max Profit = Unlimited
Downside Breakeven = 62.95
Upside Breakeven = 77.05
Current Profit/Loss = $14

Figure 1: Risk Graph of XOM Straddle
click here for larger view

This past week saw a nice rise in the IV of both the call and put in our straddle. In fact, IV on the call rose from 20.3 to 23.8 (17.2%) with the put moving from 21.6 to 25.0 (15.7%). This change in IV is the reason the trade went from a loss of $68 last week to a profit of $14 this week. XOM shares moved from $73.12 to $73.57 with the stock now sitting at resistance. The hope is that IV will continue to rise and the stock will jump further ahead of its earnings report Thursday.

With earnings this week, we need to discuss possible exit strategies. When deciding when to exit, especially when our profit goals have not been met, we need to look at the risks of holding through earnings. With our particular trade, there are several risks to holding through earnings. First, once the report is released, IV is likely to fall. We have seen IV rise this past week heading into the report, but this will likely decline once the news is out. The other risk is that the stock will fall given the move it has made from lows near $66 just a few weeks ago. The stock is trading at the upper end of breakeven point, so we would like to see further gains. XOM shares would have to drop substantially for a profit to be made to the downside at this point. Although a sharp decline would likely lift IV as well.

Each trader will have to weigh out the rewards and risks individually depending on their risk tolerance and outlook. We will show next week the results for both scenarios. In the meantime, feel free to ask questions about this strategy or any other questions you have at my forum, which you can access through the homepage at Optionetics.com.

Jody Osborne
Senior Writer & Options Strategist

Optionetics.com ~ Your Options Education Site