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Lesson 9 - Tools for Options Trading Success

by Uncle Bob Williams

At Uncle Bob's Money, we focus on 4 proven income generating Options strategies that Pit Traders have been using for many years. We are not creating or testing any new techniques. These are strategies that have proven the test of time in all kinds of Market conditions. Because Options are more complex than stocks and because the rules on how to trade these strategies are only known to a small group, there are many companies who make money teaching others how to trade these strategies.

We provide all the learning materials for free on our Website: http://www.UncleBobsMoney.com

This way we can learn about Options and how these strategies work before we put our hard earned investment money to work with Options trading. Options trading isn't for everyone, but people that have Stocks or Mutual Funds in their portfolio are already exposed to more statistical risk than most of our Options strategies.

At Uncle Bob's Money, we focus on providing the Tools needed to easily trade and monitor these Income Generating Options Strategies.

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Uncle Bob's Money Tools:

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Checklists: The Secret to Successful Options Trading

Successful Investing requires a disciplined approach and cool decision making in all Market conditions. The strategies we trade at Uncle Bob's Money have been used by the Pros in the business since Options trading started in the 1970's and have been fine tuned by thousands of Professional Options Traders in all types of Market conditions. The Checklists that we use at Uncle Bob's Money are derived from guidelines that have evolved based on all of that trading experience, and they give us that extra edge and a higher probability of profit.

Market Conditions change, and sometimes they can change fast. Each Option strategy has its own set of rules for both finding good trades and for monitoring the trade we are in. The checklist is an exclusive feature of Uncle Bob's Money and it is critically important to profitable trading.

The norm is for "Options Gurus" to trade their strategies in all Market conditions. People pay the Gurus to trade, and so they trade, and they trade in all market conditions. When those trades end up being losers because of volatile Market conditions, the Gurus will very calmly explain how the Volatility changed or how a certain Technical Analysis (Fibonacci retracement, Ichimoku Cloud going red, etc.) showed what happened in the Market and why that caused the Options positions to have a loss.

We do things differently at Uncle Bob's Money. We trade to make a profit. We don't trade for the sake of trading, and we aren't interested in hearing some detailed technical analysis postmortem of why they lost money. We want to trade when the market conditions indicate that we have a high probability of making a profit, and we want to sit with our money in cash when the market conditions indicate it is not a good time to trade these Options strategies. One of the key values of a subscription at Uncle Bob's Money is exactly because we show when to stay OUT of the market.

Look at these 2 sample scenarios:

GURU TRACK RECORD [$1,000 invested]:

Month 1: +4% [$1,040]
Month 2: +3.5% [$1,076.40]
Month 3: +4.5% [$1,124.83]
Month 4: -15% [$956.11]
Month 5: +2.5% [$980.02]
Month 6: +3.0% [$1,009.42]

GURU GROSS PROFIT = approximately 1% [$9.42]

INVESTMENT TOTAL AFTER 6 MONTHS: $1,009.42 (If you add in Commissions cost of $6/month, there is a Net Loss of -$26.58.)

- - - Compare to Uncle Bob's Money - - -

UNCLE BOB'S MONEY TRACK RECORD [$1,000 invested]:

* Our Checklist tells us to stay out of the Market in the 4th Month. Same profit in the other months in this example, the only difference is that we make NO trades in the 4th month.

Month 1: +4% [$1,040]
Month 2: +3.5% [$1,076.40]
Month 3: +4.5% [$1,124.83]
Month 4: 0% [$1,124.83]
Month 5: +2.5% [$1152.96]
Month 6: +3.0% [$1187.55]

UNCLE BOBS MONEY GROSS PROFIT = approximately +18% [+$187.55]

INVESTMENT TOTAL AFTER 6 MONTHS: $1187.55 (If you add Commissions cost of $6/month, there is a Net Profit of $151.55 which equals 15% Net Profit.)

Using the Checklist to know when to stay out of the Market is one of our secret tools for maximum profits.

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Trade Finder Checklist

The Trade Finder Checklist constantly analyzes the key market indicators for each strategy that we trade at Uncle Bob's Money. Experience has shown that when we trade outside of the checklist parameters, our probability of profit goes down. The checklist keeps our trade selection disciplined so that we only enter trades that have the greatest probability of success.

Trade Finder Checklist Factor # 1: Time Until Expiration

Each strategy that we trade at Uncle Bob's Money has an ideal time when to enter the trades. Remember the Greek "Theta" which was the TIME gauge for Options; we saw that when the Expiration of the Option is more than 30 days away the value of the Theta is very small. (Theta is how much the price of the Option will go down after 1 day has passed assuming that the price and volatility of the underlying did not change.) The idea with our Income Generating Options trades is to be close enough to Expiration that we can profit from the bigger changes in Theta. If we trade Options that have an Expiration too far in the future, we expose ourselves to risk without getting the benefit of Theta change profit. This is why the Options that we trade are usually around 1 month away from Expiration: exactly when the Theta change starts to increase significantly.

The 'ideal' trade day is only a suggestion, and shouldn't be viewed as the only day to trade. If we see a good trade opportunity and it is in the correct time range, we will take that trade.

The Time Guidelines we use at Uncle Bob's Money:

BUTTERFLY STRATEGY
Days until Expiration: 35 days to 25 days
Ideal Trade Day: 30 days before Expiration

CALENDAR STRATEGY
Days until Expiration: 35 days to 25 days
Ideal Trade Day: 30 days before Expiration

HIGH PROBABILITY CONDOR STRATEGY
Days until Expiration: 55 days to 35 days
Ideal Trade Day: 49 or 39 days before Expiration

LOW PROBABILITY CONDOR STRATEGY
Days until Expiration: 35 days to 25 days
Ideal Trade Day: 30 days before Expiration

DOUBLE DIAGONAL STRATEGY
Days until Expiration: 45 days to 35 days
Ideal Trade Day: 40 days before Expiration

TIP: Uncle Bob's Money Trade Calendar

On the bottom of the Trade Finder, we provide a convenient Trade Calendar so we can see the Optimal trade range for each Strategy on a Calendar. We can use the Trade Calendar to schedule when we will look for Options trades.



Trade Finder Checklist Factor # 2: Price Movement

The income strategies we trade depend on the Market price of the underlying staying within a 'normal' or calm range. There is no guarantee of what will happen in the future, as a very calm market can become extremely volatile when something drastic happens in the news, and likewise a volatile market can suddenly become fairly calm when a series of good 'news' hits the streets and the overall market prices rise slowly. However, we do know that there are periods when the market is generally more volatile than others and the Price Movement checklist is our gauge to understand whether the market is relatively 'calm' or volatile.

We can compare successful Options trading to sailing. If the winds are calm or even blowing moderately, we can successfully navigate the waters and have a great time, but if there's a hurricane outside, we wouldn't want to risk capsizing or struggling non-stop to keep afloat. The same is true with successful Income Generating Options Trades: when the market is calm or relatively calm, we can successfully make our trades and bring home profits. However, when the market pricing is volatile, that is the time for us to stay on the sidelines with our strategies.

We constantly evaluate the Price Movement of the Underlying for these three time periods:

1 Week: The price of the underlying should not change more than 5% in one direction during the previous 7 days.

1 Month: The price of the underlying should not change more than 10% in one direction during the previous 30 days.

3 Months: The price of the underlying should not change more than 15% in one direction during the previous 90 days.



The price of the Underlying may oscillate up and down during each period, and that type of price movement is normal. We specifically look for a price movement in one direction that exceeds one of our target values.

We want the Market to be relatively 'calm' and stay within a range to be profitable with our Income Generating Strategies, which is why we specifically look for 'spikes' in the underlying price. A price 'spike' or a significant price movement in one direction is our Price Movement trigger to stay out of the market.

Trade Finder Checklist Factor # 3: Implied Volatility Movement (IV)

The Implied Volatility (IV) measures how much demand there is for Options. When there is fear that the Market will go down, then the demand for Options goes up, and with the increased demand is a corresponding increase in Options prices. We can compare the Historical Volatility (HV) which is a statistical analysis of the price movements of the underlying and compare it to the Implied Volatility (IV) which is the demand for Options. When the Implied Volatility (IV) is higher than the Historical Volatility (HV), we can say that Options are 'expensive': that there is a high demand for Options which indicates that people are afraid that this Stock / Index will go down.

Of the 4 strategies that we trade at Uncle Bob's Money, 3 of them are very sensitive to movement or the relative level of the Implied Volatility (IV), so monitoring the Implied Volatility (IV) is a critical checklist item.

TIP: Uncle Bob's Money Automated IV Evaluation

At Uncle Bob's Money, we have completely automated the process of evaluating the 3 parts of the Implied Volatility (IV) attributes so we don't have to pour over IV charts and try to guess if the values of the 3 different parts are within or outside the checklist range.



The 3 parts to the Implied Volatility (IV) Checklist: IV Range, Channeling and Trending.

(1) IV Value & Range

The Implied Volatility (IV) checklist indicates the current IV value for the Underlying. We use the IV of the ATM CALL (At The Money CALL) for the current Options Expiration. We also list the LOW and HIGH values for the IV for the previous 12 months, with a sliding bar indication of where the current IV value is for that 1 year range. It is important to understand where the current IV value is in relationship to the previous year range: Low end, high end, or somewhere in the middle.

Condors and Butterfly's are good to trade in High IV environments.

Calendar and Double Diagonal's are good to trade in Low IV environments.

(2) Channeling

Channeling describes the PATH of the IV line on the chart: Is the line relatively straight, or does it jump up and down? On the Uncle Bob's Money IV chart, we automatically calculate and draw 'IV Channeling' lines so we can see instantly if the IV values are staying within the Channel or not. We also indicate with a colored dot where the IV value fluctuation was the greatest.

If the IV values are jumping outside of the IV Channeling lines, it indicates that there is too much IV value fluctuation. This simply means that the fear level of the Market is jumping up and down and it is not a good time to trade certain Options strategies.

Butterfly, Calendar and Double Diagonal strategies all require IV Channeling.

Condors do not require IV Channeling.

(3) Trending

Trending describes the SLOPE of the IV line on the chart: Is the line going UP (IV increasing with time), DOWN (IV decreasing with time) or staying FLAT?

UP Trend is good for Calendars and Double Diagonals, it can be problematic but not necessarily bad for Butterflys, and it is only bad for Condors if the change up is very fast.

DOWN Trend is good for Butterflys and Condors, and it is bad for Calendars and Double Diagonals.

FLAT Trend is good for all 4 strategies: Butterflys, Calendars, Condors and Double Diagonals.

In Depth IV Value Explanation for each strategy:

First the exception:

Condors / Iron Condors are not particularly sensitive to Implied Volatility (IV) movements or the overall level of Implied Volatility (IV).

High Prob Condors do not have Implied Volatility (IV) limits. The reason is that as the Implied Volatility (IV) rises, the price of the Options also rise, so we are able to either take in a higher premium for the same risk, or alternatively we can move our Short positions further out in which case we can take less risk for the same amount of premium. If the Implied Volatility (IV) is at the very highest level for the last year, we would advise against doing a Condor. We don't specifically have a monitor for the extremely high Implied Volatility (IV) on a High Probability Condor because it would be marked RED by the Price Movement Check.

Low Prob Condors should generally be traded in a Medium to Low Volatility range, but again since the price of the Options rises with the higher volatility, we don't specifically put a RED light for Low Prob Condors based on the volatility.

When we get to the details of the different strategies, we will see that High Prob Condors are one of the easiest Option strategies to understand and to trade. While Low Prob Condors are technically the exact same type of Options trade, Low Prob Condors are held for a shorter period of time and have a higher probability of loss, so we recommend Low Prob Condors only for very advanced Options traders. (Don't be tempted by the high profit values that a Low Prob Condor offers when starting out. If the Market moves against you on a Low Prob Condor and you don't know how to handle the trade, you can have significant loses.)

Butterfly Strategy regarding Implied Volatility (IV):

Similar to a Condor, when the Implied Volatility (IV) is high, the prices of the Options rise proportionally, and since Butterflys have the same Expiration Date, the overall position value tends to be stable. If the Implied Volatility (IV) goes down, the lowered Options prices can sometimes produce a slight increase in profit when exiting the trade.

Calendars and Double Diagonals regarding Implied Volatility (IV):

It's best to utilize Calendar and Double Diagonal trades when the Implied Volatility (IV) is in the low part of its range.

With Calendars and Double Diagonals, we have Option positions in different Expiration months. The Short Position (the position we sell) is in the current expiration month, and the Long Position (the position we buy) is in the next month or the month after that. The way these strategies make money is that the Price of the Short Position, which is in the current month, will get smaller at a faster rate than the Price of the Long Position, which is in a later month. Remember that the Theta goes up as we get closer to expiration, so that each day we get closer to expiration the price of the Short Position goes down more than the price of the Long Position.

However, these trades are sensitive to Implied Volatility (IV) changes. The Implied Volatility (IV) can greatly affect the price of these Options, where the Theta has a more gentle effect on the price of these Options. If the Implied Volatility (IV) goes Down, then the prices of both our Short and Long positions will go Down. When the price of the Option goes down, then the amount of Theta also goes down. We were banking on the Theta difference to make money on these trades and when the Implied Volatility (IV) goes down, our Theta profit tool gets cut down.

Where we lose money on a Calendar and Double Diagonal trade is when we put on the trade when the Implied Volatility (IV) is high.

For example: Implied Volatility (IV) will be high when the market just experienced a down trend. Let's say that we enter a Calendar trade when the prices are high because of the high Implied Volatility (IV). Then the Market will become calmer and with the calm in the Market the Implied Volatility (IV) will go down, and the lower Implied Volatility (IV) will lower the Options prices of our trade. What happens is that we will look at all the other parameters of our trade, and everything looks perfect: the Market price is well within the range of our trade and it looks like it should be easy profits. However, the profit of our trade keep dropping and dropping and now we are looking at a small loss to exit the trade! Ouch.

That's the hard way to learn about how changes in Implied Volatility (IV) can affect our profitability.

If we turn that scenario around, and assume that we enter a Calendar trade when the Market is relatively calm and the Implied Volatility (IV) is low, we pay relatively low prices for our Options positions. If the Market starts to get a little volatile, the Implied Volatility (IV) will go up as will the Options prices. Now, instead of looking at a loss, we will see that all of sudden we are looking at large profits on the trade and we can exit our positions early and walk away with a nice set of early profits.

We see how understanding the 3 parts to the Implied Volatility (IV Range, Channeling and Trending) make a big difference as to which Strategies we will trade.

Trade Finder Checklist Factor # 4: Historical Volatility Movement (HV)

The Historical Volatility (HV) shows the statistical amount of the actual price movements of the underlying, and we include it on the Condor Trade Finder Checklist as a reference, but it does not trigger any change to the Green / Yellow / Red status. The Historical Volatility (HV) is used as a gauge to see if the current price of Options is "expensive" or "cheap".



If the Historical Volatility (HV) is lower than the Implied Volatility (IV), it means that Options are "expensive", because the demand for Options is higher than the actual price movements would indicate. The high Implied Volatility (IV) value indicates that there is fear in the Market, and people are buying Options for protection.

If the Historical Volatility (HV) is higher than the Implied Volatility (IV), it means that Options are "cheap", because the demand for Options are lower than the actual price movements.

Trade Finder Checklist Factor # 5: Standard Deviation Range

The Standard Deviation Range is provided as a reference on the Trade Finder Checklist. For all the strategies we trade at Uncle Bob's Money, it is important to know where the 1 and 2 Standard Deviation price movement marks are for the selected Expiration. The list of possible trades may technically fall within the "GREEN" lights of the checklist, but it's a personal decision based on comfort level whether to select specific trades or not: The main gauge for that personal decision is the Standard Deviation Range. (We use the IV of the At The Money Call to calculate the Standard Deviation Range. If the underlying price is between 2 Call Strikes, we take the higher IV value to calculate the Standard Deviation Range.)



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Trade Monitor Checklist

After we have selected and logged specific trades in our Uncle Bob's Money account, the Trade Monitor Checklist constantly analyzes the key market indicators for each strategy that we have in the Trade Monitor.

Remember: If we want to actually trade these positions live in our Brokerage account, we must make the trades in our Brokerage Account. Uncle Bob's Money is not a Broker and there is no money or actual trading happening on our system. Any trades that are "logged" are only fictitious "paper" trades.

After we executed the actual live trades at our Broker, we can enter the real trade values into the Uncle Bob's Money Trade Monitor so we can use the Uncle Bob's Money Trade Monitor Checklist and Trade Monitor tools to evaluate our Options positions.

Trade Monitor Checklist Factor # 1: Time In Trade

In the Trade Finder Checklist, the key Time issue is when to enter the trade. However, on the Trade Monitor, the key time issue is how long are we in this trade and how close is it to expiration. With Calendar and Double Diagonal trades, where our positions are split across different expiration months, we do not want to let our Short position go to expiration. The expiration settlement value can vary greatly from the current Market price, and we could face a significant loss exiting from the trade. As long as both Option positions are live, the relative values between our Short and Long positions will stay constant, so we always want to exit Calendars and Double Diagonals before expiration of our Short strike.

Calendar Trades:

=> If 22 Days or More in the trade, then the Time in Trade checklist will show YELLOW/ORANGE. It is OK for us to stay in the trade during this time as long as we are monitoring the position.

=> If 3 days or Less until Expiration, then Time in Trade will show RED and we should close the positions to exit this trade. The Gamma will increase as we get very close to expiration, and it can do strange things to the price of our Options. It is best to avoid possible volatlity problems that can occur just prior to expiration.

NOTE: It's important to remember the saying, "I never had a loss taking a profit." It is a smarter Options trading policy to cash out and take our profit from a good trade, than to keep in the market to try to squeeze out a few more dollars of profit. The key to successful Income Generating Options trades is to be exposed to the Market as little as possible. When we have a nice profit, we close the positions and walk away with our earnings.

Double Diagonal:

=> If 26 Days or More in the trade, then the Time in Trade checklist will show YELLOW/ORANGE. It is OK for us to stay in the trade during this time as long as we are monitoring the position.

=> If 3 days or Less until Expiration, then Time in Trade will show RED and we should close the positions to exit this trade.

Butterfly Trade:

=> If 21 Days or More in the trade, then the Time in Trade checklist will show YELLOW/ORANGE. It is OK for us to stay in the trade during this time as long as we are monitoring the position.

=> Butterfly trades never go Red for Time in Trade. Since all the positions are in the same expiration month, it is OK to hold until expiration.

NOTE: The settlement value of the Options after expiration can vary greatly from the closing and opening price of the underlying. Since Butterflys generally have a narrow range of profit, it can be risky letting the Butterfly go until expiration. However, it is exactly at expiration when the Butterfly trade has the greatest profits. We just need to be aware of the risks and the rewards when allowing a Butterfly trade to go until expiration.

Caveat: Don't let a Stock Settled Butterfly go until expiration. The settlement of the actual stock could cause a lot of headaches and unnecessary expenses. We only suggest allowing a Butterfly to go until expiration on CASH SETTLED Indexes.

Condor Trade:

Condor trades will not show any color change since it is OK to hold them until expiration. (Again, only on Cash Settled Indexes. Condor spreads on a stock settled symbol should be closed prior to expiration.)

=> High Prob Condors are generally held until expiration.

=> Low Prob Condor positions are for advanced traders, and we generally exit the trade after 16 or 17 days. If after 18 Days or More in the trade, it is OK for us to stay in the trade during this time as long as we are monitoring the position.

Trade Monitor Checklist Factor # 2: Price Movement

This is the same checklist as the Trade Finder. Large price movements of the underlying will trigger a RED light on Price Movement.

1 Week: The price of the underlying should not change more than 5% in one direction during the previous 7 days.

1 Month: The price of the underlying should not change more than 10% in one direction during the previous 30 days.

3 Months: The price of the underlying should not change more than 15% in one direction during the previous 90 days.





Trade Monitor Checklist Factor # 3: Implied Volatility (IV) Change

As we mentioned above in the Trade Finder Checklist Factor for Implied Volatility (IV), noticeable changes in the Implied Volatility (IV) for Butterfly, Calendars and Double Diagonals can have significant changes to our profit/loss.

IV CHANGE in a BUTTERFLY:

=> IV Trending UP is Bad = RED.

When the IV is going UP, the price of the Options will also rise. All of our positions in a Butterfly strategy are in the same month. The prices of our 2 LONG positions should stay relatively stable as regards to the SHORT position; however, the Short Positions which we sold to enter this trade have the highest time value and the highest price when we enter the trade. On Butterflys that we do not hold until expiration, we profit when the price of our SHORT positions goes down, making it cheaper to buy those positions back and we make a profit. When the IV goes UP, the price of our SHORT positions will rise, and it is possible to have a loss trying to exit this trade.

=> IV Trending DOWN is Good = GREEN.

When the IV is going DOWN, the price of the Options will also go down. The prices of our 2 LONG positions should stay relatively stable as regards to the SHORT position; however, the Short Positions which we sold to enter this trade have the highest time value and the highest price when we enter the trade. On Butterflys that we do not hold until expiration, we profit when the price of our SHORT positions goes down, making it cheaper to buy those positions back and we make a profit. When the IV goes DOWN, the price of our SHORT positions will go down, and we should be able to exit this trade early with a healthy profit.

IV CHANGE in CALENDARS & DOUBLE DIAGONALS:

=> IV Trending UP is OK = GREEN.

When the IV is going UP, the price of the Options will also rise. The price of our LONG position which is further out in time will rise more than our SHORT position which is in the current expiration month. We should be able to exit this trade early with a healthy profit. (IV going up means there is more demand for Options, and generally that happens when the Market prices drop.)

=> IV Trending DOWN is Bad = RED.

When the IV is going DOWN, the price of the Options will also go down. The price of our LONG position which is further out in time will drop more than our SHORT position, which is in the current expiration month. We could have a loss on this trade. (IV going down means there is less demand for Options, and this generally happens when the Market prices are rising; people feel positive and less afraid of a downturn.)

IV CHANGE in CONDORS:

We do not use IV change as a RED indicator for Condors. It is true that when the IV goes UP, the price of our Options should also rise, but the Market price might be too far away from our Short Strike to be an issue. Our positions on a Condor will probably have a very low VEGA value: the amount of change of our Options price based on a 1% change in the Volatility. It is possible, with a Condor, to have a large change in the Volatility, but only a very minor change in the Options prices.

The key factor for determining when to exit a Condor early is the Delta of the Short Strike, and we will watch the Delta of the Short Strike independent of the IV value.

On the positive side, a drop in IV should reduce the price of our Options, and while that price drop may be small, it might be enough to allow us to exit the trade early with a healthy profit.

Trade Monitor Checklist Factor # 4: Key Indicators for each strategy

Since each Strategy has its own specific Key factor to monitor which indicates when an early exit is desirable, on the Uncle Bob's Money Trade Monitor we prominently display the Key Indicator on each Strategy.

We show the status of the Key Indicator at all times, and we will show a RED light when the Key Indicator hits the following warning levels:

KEY INDICATOR TO EXIT A BUTTERFLY: IV Trending UP

KEY INDICATOR TO EXIT A CONDOR: DELTA of the SHORT STRIKE hits 30.

(You can customize the Delta value which will trigger a Red light.)

KEY INDICATOR TO EXIT A CALENDAR: IV Skew

The IV Skew is the Key Indicator for both the Calendar and Double Diagonal strategies.

EXPLANATION: The IV Skew is the difference between the IV of the SHORT Strike in the Current Expiration Month (sometimes called: the Front Month) as compared to the IV of the LONG Strike in the month further out (sometimes called: the Back Month).

Acceptable IV Skew Range: -2 to +5

A Positive IV Skew of 5 or more is a RED flag to exit the trade.

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Example of the IV Skew on a Calendar trade.

We have a Calendar on Acme:

=> Current price of Acme (underlying) is 100

=> Our Calendar spread:

SOLD 1 | ACME | JUNE | 100 | CALL | IV: 21.38% (Front Month)

BOUGHT 1 | ACME | JULY | 100 | CALL | IV: 22.06% (FroBacknt Month)

[Front Month IV - Back Month IV = IV Skew]

The IV Skew is: 21.38 - 22.06 = -0.68 This is a Negative Skew of -0.68

-0.68 is within our IV Skew range of -2 to +5, so this IV Skew is OK.

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KEY INDICATOR TO EXIT A DOUBLE DIAGONAL: IV Skew and IV Goes Down

With Double Diagonal trades, we want to pay especially close attention to both the IV Skew and whether the IV goes Down. We mentioned above that Calendar trades are also very sensitive to IV Down Trends. However a little extra attention should be paid to IV Down Trends on a Double Diagonal, so we include it in the Key Indicators.

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See Lesson 10: Conditional Orders

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