Who Decides What an Option Is Worth?
A Beginner’s Guide to Option Pricing
Part 1 – Where Do Option Prices Come From?
If you’ve ever looked at an option chain, you’ve probably wondered how those prices are determined.
A stock is easy enough to understand. If NDVA is trading at $210, that’s simply the last price at which a buyer and seller agreed to trade.
But options seem much more mysterious.
Why is one option worth $3.20 while another is worth $5.80? Why do calls and puts with the same strike price often trade at different prices? Why do option prices sometimes seem perfectly logical, while other times they appear almost random?
Most investors assume there must be a giant computer somewhere calculating the “correct” price for every option.
Others assume option prices are determined entirely by supply and demand.
As it turns out, both ideas are partly right—and both are partly wrong.
Understanding how options are really priced requires thinking about them differently than we think about stocks.
This article is the first in a series that will build that understanding from the ground up.
By the end of the series, you’ll understand not only why options have the prices they do, but also why the option chains of a quiet stock like Veeva Systems (VEEV) look completely different from those of one of the world’s busiest option markets, NVIDIA (NVDA).
But before we can understand those examples, we need to answer a much more fundamental question.
Who actually decides what an option is worth?
The surprising answer is:
No single person does.
Instead, every option price is the result of three different forces working together.
- The first is mathematics.
- The second is professional market makers.
- The third is ordinary buyers and sellers.
Understanding how those three forces interact is the key to understanding every option chain you’ll ever see.
An Option Is Different from a Stock
One reason options seem confusing is that they aren’t assets in the same way that stocks are. When you buy one share of a company, you own a tiny piece of that business. The share itself has value because it represents ownership.
An option is different. It is simply a contract.
A call option gives its owner the right—but not the obligation—to buy 100 shares at a specified price before a certain date.
A put option gives its owner the right—but not the obligation—to sell 100 shares at a specified price before a certain date.
An option isn’t valuable only because of what the stock happens to be worth right now.
Some of its value comes from that — but a large part of an option’s price comes from something else entirely: uncertainty about where the stock might go before the contract expires.
We’ll unpack that distinction — between an option’s value tied to the stock’s current price and the value tied to pure uncertainty — in more detail in a later part of this series. For now, the important idea is this:
Options don’t behave like simple ownership stakes. A meaningful part of their price reflects possibility, not just present value.
Why Pricing an Option Is So Difficult
Imagine someone offers you a contract that says:
“For the next six months, you may buy a house for $500,000 whenever you choose.”
How much would you pay for that contract?
At first, the answer seems simple.
If the house is currently worth $500,000, perhaps the contract isn’t worth much.
But what if housing prices rise?
Suppose six months from now the house is worth $600,000.
Suddenly that contract is incredibly valuable because it lets you buy a $600,000 house for only $500,000.
On the other hand, what if housing prices fall and the house becomes worth only $450,000?
Then the contract becomes worthless because you could simply buy the house in the open market for less.
Notice the problem.
To decide what the contract is worth today, you must somehow estimate everything that might happen over the next six months.
But nobody can know the future. They can only estimate probabilities.
Pricing an option involves exactly the same challenge.
The question isn’t simply where the stock is today.
The real question is: Where might the stock be before the option expires?
The Difference Between Theoretical Value and Market Price
Before we go any further, we need to separate two ideas that are often confused.
The first is an option’s theoretical value.
The second is its market price.
Suppose you own a home. You hire a professional appraiser. After inspecting the property and comparing it with recent sales, the appraiser concludes your house is worth $550,000.
That number is an estimate.
Now imagine two neighbors both fall in love with the house and a bidding war begins. One eventually agrees to pay $610,000.
Was the appraiser wrong?
Not necessarily. The appraisal estimated what the house should be worth under normal market conditions.
The actual selling price reflected how badly two people wanted that particular house.
The appraised value and the market price answered two different questions.
Options work the same way.
Professional pricing models estimate what an option should be worth based on today’s information.
The market determines what someone is actually willing to pay.
Most of the time, those two numbers land close together. Occasionally, they diverge — sometimes sharply. Understanding why is one of the central ideas in options trading, and it’s something we’ll return to throughout this series.
One of the biggest mistakes new option traders make is assuming that there is always one “correct” price for an option.
There isn’t.
The Birth of Modern Option Pricing
Until the early 1970s, options were often priced largely by experience and intuition.
Professional traders developed a feel for what an option “ought” to be worth, but there was no universally accepted mathematical framework for calculating that value.
That changed in 1973. Economists Fischer Black and Myron Scholes published a paper that transformed financial markets. That same year, Robert Merton independently published his own extension of the math, filling in gaps in the original model — work significant enough that the framework is now often called the Black-Scholes-Merton model in academic circles.
For the first time, traders had a mathematical framework that estimated what an option should be worth based on measurable factors.
The model considered things such as:
- the current stock price
- the strike price
- the time remaining until expiration
- interest rates
- dividends
- the expected volatility of the stock
The result wasn’t a guaranteed price.
It was a theoretical value—an estimate of what the option should be worth if the assumptions of the model held true.
The importance of Black-Scholes cannot be overstated. It fundamentally changed the options market and remains the foundation of modern option pricing.
However, it’s equally important to understand what Black-Scholes doesn’t do. It does not determine the price at which an option must trade. It simply provides an estimate.
That’s a distinction that many beginner books blur, and it’s one of the biggest sources of confusion for new investors.
Black-Scholes Is the Wright Brothers, Not the Boeing 787
When people first hear about Black-Scholes, they sometimes imagine that every option in the world is priced using the exact same equation that was published in 1973.
That isn’t how today’s markets work. Think of the Wright brothers. Their airplane changed aviation forever. But no airline today flies passengers across the Atlantic in a 1903 Flyer.
Modern aircraft are vastly more sophisticated, even though they all trace their origins to that first successful flight.
Option pricing models have evolved in much the same way.
Today’s professional market makers employ teams of mathematicians, physicists, computer scientists, and quantitative analysts who have spent decades improving on the original ideas.
Modern pricing systems account for things the original Black-Scholes model handles imperfectly, including changing volatility, early exercise, dividend schedules, market liquidity, large price jumps, and many other real-world complications.
Each major trading firm has developed its own proprietary pricing models. Those models are among their most valuable trade secrets because even tiny improvements in pricing accuracy can be worth millions of dollars over thousands of trades each day.
Although these systems are much more sophisticated than the original Black-Scholes equation, they all share the same basic purpose. They estimate an option’s theoretical value. But an estimate is not the same thing as a market price.
And that brings us to perhaps the most misunderstood concept in all of options trading.
Implied volatility.
End of Part 1
