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How to Price and Trade Options: Identify, Analyze, and Execute the Best Trade Probabilities, + Website by Al Sherbin

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CHAPTER 3 Building the Foundation

Though some may find this chapter a bit technical, I believe it is the most important chapter in the book. If you do not know what a call or put is, or are not aware of the Greeks and what they tell us, you may want to do a little (free) research on the Internet before digging in.

I will begin with a short history of option pricing models, but will stay away from the math, for the most part. My goal here is to explain the inputs that go into the pricing of options, which might affect your decision-making process. We will also discuss the probabilistic nature of options. It is this nature that allows us to be “consistently” profitable over long periods of time with our options trading. But so there is no misunderstanding, “consistently” does not equate to “always.” Probability dictates we will have periods of drawdown (loss). But if we learn a proper mechanical trading style that takes advantage of the probabilities inherent in option pricing, we should be able to be profitable virtually every year in our trading. This includes periods when the overall market has negative returns, both small and large. We will also begin our journey into a discussion of options volatility, both implied and historical, and discuss their essential role in trading probabilities and in trading profitability.

Option Pricing Models

The first commonly recognized option pricing model was published in 1973 by Fischer Black and Myron Scholes as a result of their attempt ...

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