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Deep Diagonals Trading Plan

A) Definition of Success
Follow investing Plan Protect and preserve capital 60-70% of trades are winners Make a minimum ROI of 50% per trade Income vs. Capital gain play (1 month vs. several months)

B) Watchlist Criteria
Bearish o Stocks in Bearish Portfolio or watchlist (Anticipating the Bounce Part 2) o Market posture Bearish or neutral, and forecast bearish or neutral for the predicted trade length o Poor fundamentals, industry group rank <40, acc/dist <40, downtrend on the 30 dMA o Advanced model includes tracking stocks to know which DMA that one follows Bullish o Standard InvesTools Bull Fundamentals, Phase 1 and Phase 2 scores, Acc / Dist above 60 o Bullish Posture

C) Entry Rules
Stock price expected to continue to trend down or sideways for the duration of the trade Consider legging into the trade. Enter the long side as the Stock price bounces down from resistance and the MACD rolls down. Enter the short side when the price bounces up Confirmation for naked entry is at least two days of trend Enter short as MACD rolls up 2 days in a row, preferably before green arrow appears

Long Option
This is slightly different than last version. The absolute value of the Long Deltas is lower. This better reflects what I actually traded and found. First buy the long option. Long side is deep ITM, with delta 0.71-0.73 for buying Puts, for buying Calls use .73-.75. Use the deltas as shown on the Market Matrix at Investools DO NOT USE TOS Option chain deltas they are different and will affect the trade risk VERY GREATLY.

The default in TOS for Volatility Strategy is Individual Implied Volatility which should be used for Vertical and calendar strategies. If you must use TOS, change Volatility Strategy in Setup (upper right corner of Monitor Tab) to Volatility smile approximation. This will make the Theoretical price calculation in TOS vary greatly from the mid-price calculation of Bid and Ask that most users depend on. In TOS you can not have theoretical price and deep ITM deltas both correct at the same time. Buy the long option about 3-4 months out. If the market is bearish, make sure that if the trade is entered near earnings, the expiration of the long option has the same relationship to earnings. This helps manage the Vega risk.

Short Option
Sell the short side OTM, with delta 0.28-0.32. The short is front month or the next month if front month is very close. The difference between the long and short delta should be around 0.4 at this point. The difference in deltas provide the risk management for avoiding delta inversion where the near term delta exceeds the long term delta and even with the direction right you start to lose money.

D) Trade Management and Rolls


Rolling is the key to making a profit in a Diagonal Spread o Buy back the short option and sell another at any point if the value is now 20% of what you sold, or 33% if the value drops very rapidly (a day or two) o Buy back the short at any time if it is worth less than $0.10 o Buy back the short option if the delta decreases by 0.2 or more o If the underlying is moving away from you (against the long), sell another short! If the underlying is trending strongly in your long options favor, leave it uncovered until the price bounces Confirmation of bounce is 2 days change in direction. When selling another short option, re-check the Market Matrix delta of the long option, and make sure the new short is about 0.4 different in delta from the long option Roll the long when the delta gets to ~-.95 or .95 in a Bullish trade. If the trend looks to be continuing, roll out to the next expiry that has the same relationship to earnings. If the trend is changing, but not yet reversed, roll closer to ATM, and select a new strike with a delta of approximately -.73 -- -.75. You will either get several months additional time for no cost, or additional contracts for no cost, either way allowing more shorts to be sold for the duration.

E) Exit Rules
Monitor position daily

Exit if trend definitely reverses (e.g. breakout with volume after news, etc), broken resistance, etc Losing trade may be exited early when the spread has lost 50% amount of its opening value - discretionary. If confident of direction, consider rolling with the punch and sell more shorts by following the 3rd sub-bullet from the first bullet in D). In the last month before expiration of the long option, consider the final exit. Aim to exit at least 2 weeks before expiration to avoid maximum theta decay on the long side. The final trade may be a vertical, or just sell the long option If the trend is continuing, roll long out.

F) Money Management
Re-enter short position as frequently as possible to generate highest possible returns Position-size for a debit trade. E.g. if 1% total portfolio risk is acceptable, enter the trade calculating a 50% max loss to be no more than 1% of the total portfolio for $100,000, this would be a $1,000 max loss. Final profit is calculated by adding the final credit for the long option to all of the net credits from selling the short options, then subtracting the entry purchase price of the long option.

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