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

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 23

Models and the Real World

A trader who uses a theoretical pricing model is exposed to two types of risk—the risk that the trader has the wrong inputs into the model and the risk that the model itself is wrong because it is based on false or unrealistic assumptions. Thus far we have focused primarily on the first area, the risk associated with the inputs into the model. A trader will typically deal with this risk by paying close attention to the sensitivities of an option position (i.e., delta, gamma, theta, vega, and rho), thereby preparing to take protective action when market conditions move against him. While any of the inputs into the model may represent a risk, we have placed special emphasis on volatility because it is the one input ...

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