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The Complete Book of Option Spreads and Combinations: Strategies for Income Generation, Directional Moves, and Risk Reduction, + Website by Scott Nations

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CHAPTER 2

Just a Little Math

Understanding just a little of the math inherent in option trading will make you a vastly better trader. You’ll understand that certain strategies are fundamentally superior to other strategies, but most importantly, you’ll understand why that is the case. Once you understand the “why,” you can start to weave this knowledge into your decision making, both when selecting an initial option strategy and when closing or spreading out of an existing trade.

In this chapter we’ll focus on the price of an option versus the value of that option, how option prices erode over time and what this means for both option buyers and option sellers, and, finally, how changes in the inputs to an option price—inputs such as time to expiration, volatility, movement in the underlying stock, and a couple of others—will impact the price of an option. We’ll also discuss the website that accompanies this book, www.OptionMath.com. We’ll explain how to use the site and how the tools there can help you make better trading decisions.

The Option Price

The price of an option is determined solely by market demand and supply. Willing buyers and sellers come together, usually electronically, and trade at mutually agreeable prices. But don’t think for a moment that this price is equal to the value of the option. While a number of sophisticated formulas exist to determine the value of an option, ultimately the value is unknowable until expiration. Option market participants all ...

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