Exxon Mobil (NYSE:XOM) is attractive based on valuation at Monday's close of 69.15, but low beta and implied volatility suggest it will not make rapid price moves. For those who seek higher returns, the use of options to provide leverage makes the situation more interesting. XOM needs no introduction: the company is well known and heavily followed by professional analysts. I think a diagonal spread, long in-the-money LEAPs and short out-of-the-money calls makes good sense here. I will briefly state a simple case for going long the stock, followed by a longer discussion of the options strategy I am using on it, including an analysis of downside risk.

**10 Year Average EPS** – Noting that XOM has a history of buying back their own shares, consider a 10 year average EPS. The computation is, I add up ten years of net income, divide by ten, and then divide by current shares outstanding, arriving at a figure of 5.28 for the ten years ending in December 2008. Dividing this into a recent share price of 69.15, I get a P/E of 13, fairly low in my opinion. A midpoint price for XOM is about 15 X long term average EPS.

Is there any reason not to expect that the future will proceed along the same trajectory as the past? With demand from China and India picking up energy prices will probably go higher over the next ten years, so XOM should logically do better too. A conventional multiple of 15, applied to 5.28 gives a target of 79, with the shares trading around 69 the most likely path is upward. Beta here is .5, implied volatility is 26.8% - XOM is a slow mover. But it should slowly and surely wend its way upward. When last I owned the stock, I sold it for 89.48, so getting up to 79 seems doable.

**Options for leverage** – in order to receive higher returns, an investor/speculator might consider a diagonal call spread. This is similar to a covered call, but a long term option has been substituted for the underlying. Here is my analysis of the position:

Buying the Jan11 55 Call, the time value is very affordable, because of the low volatility. Long calls are cheaper when there is a dividend involved. I compute the time value as hypothetical interest on the additional 55 per share that would be required to buy rather than controlling by the use of options.

Selling the Jan10 70 call, the time value is higher when annualized, and can be looked at as 48.68% interest on the 14.50 expended to buy the long call which is serving as the underlying.

The projected option prices were developed by means of an options estimator tool provided by CBOE on their website. Projecting options prices is necessarily a guess because volatility cannot be known in advance.

If at the first expiration in January 2010 the stock is over 70, for example, 75, then a one contract position will have a gain of 555, on a net investment of 1,159, returning 115.7% annualized. If the stock is unchanged at expiration, the short call expires worthless, for an estimated profit of 204 after allowing for the time decay of the Jan11 55 call. The return is 42.5% annualized.

Break-even would be approximately 62.83 as of the first expiration date.

Looking at downside risk, the 52 week low is 56.51. If the stock hit that price in January 2010, one year before the expiration of the Jan11 55 call, the value of that option would be 7.43, according to the CBOE estimator. While this is serious compared to the original investment of 11.59, in order to put that 52 week low in perspective, here is a 1 year chart:

Eyeballing the chart I see support at 65, again according to CBOE's estimator if the stock was at 65 in January 2010 the Jan2011 55 strike should be worth 13.19, and the position's return at that point would be 33.4% annualized.

Assuming there has been no change in XOM's fundamentals, if in January 2010 this position has turned badly against the investor it would be reasonable to hold looking for the stock to recover to the 65 area which is credible support. Rolling down would also make sense, since it would cost about 3 to roll down to the 50 strike, positioning for some additional salvage in the event the share price recovers.

At some point another call could be sold, maybe 90-180 days out, the 70 strike is attractive as there seems to be resistance at 70-72.

**Summary** – XOM is undervalued based on 10 year average EPS. Based on the past year's price history and projections of this option position's value at multiple share prices as of the Jan2011 expiration of the call sold, the overall risk/reward ratio is attractive.

**Disclosure** – Net Long XOM as described.