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Option Volatility and Pricing: Advanced Trading Strategies and Techniques, 2nd Edition by Sheldon Natenberg

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 20

Volatility Revisited

When a trader enters a volatility into a theoretical pricing model, what exactly is he feeding into the model? We know the mathematical definition of volatility—one standard deviation, in percent terms, over a one-year period. Beyond this, we still have the question of interpretation. Does the number represent a realized volatility or an implied volatility? Are we talking about historical volatility or future volatility? Long term or short term? The volatility a trader chooses may vary depending on the answers to these questions.

Consider this situation:

               Underlying price = 100.00

               Time to expiration = 8 weeks

               Interest rate = 0

               Implied volatility = 20 percent ...

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