Binominal formula

If we label the r objects as belongs to the group and the remaining objects as does not belong to the group, whatever the group of interest, the combination formula tells us how many ways we can select a group of size r. We can illustrate this formula with the binomial option pricing model. This model describes the movement of the underlying asset as a series of moves, price up (U) or price down (D). For example, two sequences of five moves containing three up moves, such as UUUDD and UDUUD, result in the same final stock price. At least for an option with a payoff dependent on final stock price, the number but not the order of up moves in a sequence matters. How many sequences of five moves belong to the group with three up moves? The answer is 10, calculated using the combination formula (“5 choose 3”):

5C3 = 5! /(5−3)!3! =(5)(4)(3)(2)(1)/(2)(1)(3)(2)(1) = 120 / 12 = 10 ways

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