Last week we started a new Real-World Trading series discussing a straddle. This strategy is used when we expect a large move in a stock, but we aren't sure in which direction. There are some keys that need to be followed in order for a straddle to be successful:

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.

This week we will set up a mock trade so that we can follow the week-to-week movement in the underlying, giving us a clearer picture of how the strategy works. Before we choose a stock to enter a mock trade on, let's discuss Rule #1.

We often talk about IV and how it compares to its mean. Remember, the mean is the average of a given set of figures. Calculating the mean for implied volatility could be done by taking all the IV readings over a given time, adding them up, and then calculating the average. An easier way is to look at an IV graph. Below is a graph of IV for the past two years for the Nasdaq 100 Trust (QQQQ).

Figure 1: IV Graph of QQQQ

We can see from the graph above that the Qs have shown a lot of volatility the past few years, something that is consistent with most equities given the recession. However, we also can see that the IV tends to move back to the mid 20's. The idea with a straddle is that we don't want to be in options that could suffer a large IV crush.

Let's look at an example of how an IV crush can impact the value of a straddle.

XYZ = 50
90-day ATM call @ 30% IV = 3.03
90-day ATM put @ 30% IV = 2.91

90-day ATM call @ 20% IV = 2.04
90-day ATM put @ 20% IV = 1.92

This shows that all other things staying constant, the value of a straddle would be about a third lower just from a change in IV from 30 percent to 20 percent. This would hold true in the reverse direction also, so we would much rather be in options that the odds are in favor of an increase in IV, not a decline.

Straddles are often set up using stocks that have impending news. Earnings are an event that is predictable, happens four times a year and this news often has a major impact on not only the stock's price, but the option's implied volatility. As earnings season approaches, one way to find possible straddle candidates is the following:

1. Look at a list ranking of cheap options. This can be done by creating your own cheap option scan, or by using one of the precomputed list on the Optionetics Platinum site. The Cheap: 1 Year list shows Exxon right on top.
2. Look to see when earnings are expected. In this case, XOM is set to report at the end of October.
3. See if IV tends to move ahead of earnings.
4. Look at a chart for favorable set ups.

XOM fits these entire criteria and the daily chart is favorable as well. Below is a daily chart of XOM.

Figure 2: Stock Chart of XOM

I like several things about this stock chart. First, we see a run up in price heading into earnings for the past two reports. Second, the chart has formed a triangle formation, which means the lows are rising while the highs are decreasing. This often leads to a big move once the triangle is broken.

When setting up a straddle, we need make sure we use options that will not enter their last month of trading before the event we are looking for can occur. This is because the last 30-days of an option's life will see a dramatic pick up in time decay. Therefore, we are going to use the Jan10 options instead of the November options. Below is the data for this trade:

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 = 77.05Profit Expectation = $350

Figure 3: XOM Risk Graph

There are a couple of deceptive things about the data we listed above. This is because we do not expect to hold this trade once the options have less than 30-days until expectation. In fact, we likely won't hold it past earnings and this means we will still have 75-days left. When we look at the risk graph above, we see that with 73-days left (i.e. the blue line) we can only lose a little more than $100. If IV rises, like we expect it to do, then the max loss would be even lower.

We will continue to track this mock trade through the earnings announcement set for the end of October. In the meantime, please feel free to ask questions and provide comments on my forum, which you may access through "Ask the Traders" from the Discussion board on the homepage of Optionetics.com and I will make sure to answer them in upcoming articles and on the discussion board.

Jody Osborne
Senior Writer & Options Strategist
Optionetics.com ~ Your Options Education Site