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Volatility Skews

There are clearly real problems associated with the use of a traditional theoretical pricing model. Markets are not frictionless, prices do not always follow a diffusion process, volatility may vary over the life of an option, the real world may not look like a lognormal distribution. With all these weaknesses, one might wonder whether theoretical pricing models have any practical value at all. In fact, most traders have found that pricing models, while not perfect, are an invaluable tool for making decisions in the option market. Even if a model does not work perfectly, traders have found that using a model, even a flawed one, is usually better than using no model at all.

Still, a trader who wants to make the best possible ...

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