A Beginner’s Guide to Option Pricing
Part 1 – Theoretical Value and Market Price
How are option prices determined?
A stock is easy enough to understand. If NVDA is trading at $210, that’s simply the last price at which a buyer and seller agreed to trade.
But options seem more complicated. 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?
Some traders may assume there’s a giant computer somewhere calculating the “correct” price for every option, but that’s not how it works. Nor are option prices determined entirely by supply and demand, although supply and demand have an impact.
Both ideas are partly right, and partly wrong. Understanding how options are 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. Along the way, we’ll cover pricing-related topics like theoretical value and implied volatility, and we’ll see why the option chains of a quiet stock like Veeva Systems (VEEV) look very different from those of one of the world’s busiest option markets, NVIDIA (NVDA).
Let’s start with a fundamental question: who actually decides what an option is worth?
No single person makes this determination. Instead, every option price results from three forces working together: mathematics, professional market makers, and 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 stocks are. When you buy one share of a company, you own a tiny piece of that business, and the share has value because it represents ownership. An option is different. It’s 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.
(Options are also called derivatives because the contracts are based on the movement of an underlying item—shares of a company—rather than the shares themselves. It’s a distinction worth thinking about: when you own a stock, you own a piece of a business. When you own an option, you own a contract about that stock, and that contract has its own separate life—its own expiration date, its own sensitivity to time and uncertainty, and its own way of losing value even if the stock does nothing at all. This is something many investors gloss over. They treat a call option like a cheaper way to “buy the stock,” when in practice they’ve bought something structurally very different.)
We’ll unpack the distinction between an option’s value tied to the stock’s current price and the value tied to pure uncertainty in more detail in Part 2. For now, the important idea is that 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 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?
If the house is currently worth $500,000, the contract might not seem worth much today. But suppose housing prices rise and the house is worth $600,000 in six months—suddenly the contract is valuable, since it lets you buy a $600,000 house for $500,000. Suppose instead prices fall and the house is worth only $450,000—now the contract is worthless, since you could simply buy the house for less on the open market.
That’s the core problem: to decide what the contract is worth today, you have to estimate everything that might happen over the next six months.
Nobody knows the future; they can only estimate probabilities. Pricing an option involves that same challenge. The question isn’t simply where the stock is today, although that matters—it’s also where the stock might 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: an option’s theoretical value, and its market price.
Suppose you own a home and 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.
The appraiser wasn’t necessarily wrong; the appraisal estimated what the house should be worth under normal conditions, while the actual selling price reflected how badly two people wanted that particular house. The appraised value and the market price diverged.
Options work the same way. Professional pricing models estimate what an option should be worth based on today’s information, while 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 mistake new option traders often make is assuming, incorrectly, that there’s always one “correct” price for an option. But there isn’t.
What “Theo Value” Means in an Actual Option Chain
Some option chains include a column labeled “Theo” or “Theoretical Value.” That number is an estimate produced by an option-pricing model, but it should not be mistaken for an official or universally correct price. It is the value generated by that particular platform using its own assumptions about volatility, interest rates, dividends, time remaining, and the current price of the stock. Another brokerage or market maker could use different assumptions and arrive at a different theoretical value for the same contract.
Comparing Theo with the market also requires care. The “Last” column merely shows the price of the most recent completed trade. A better picture of the current market comes from the bid and ask: the bid shows what a buyer is presently offering, while the ask shows what a seller is presently requesting. The midpoint between them is often used as an approximate current value, although an investor may not necessarily be able to execute a trade at that price.
A difference between Theo and the current market does not necessarily mean an option is mispriced. It usually means that the platform’s assumptions differ from the assumptions embedded in current market prices. Volatility is especially important. Market prices can imply different volatilities at different strikes, while a platform’s theoretical-value calculation may use a single or smoothed volatility estimate. The resulting theoretical value may be above or below the market without the difference necessarily indicating a mispricing. The model is estimating what the option should be worth under one set of assumptions; the market is showing the prices at which actual buyers and sellers are currently willing to trade.
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, when 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 current stock price, the strike price, the time remaining until expiration, interest rates, dividends, and 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 model’s assumptions held true. The importance of Black-Scholes cannot be overstated; it fundamentally changed the options market and remains the foundation of modern option pricing. But it’s equally important to understand that Black-Scholes doesn’t determine the price at which an option must trade. It simply provides an estimate. That distinction can be a source 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 is still priced using the same equation published in 1973. But that isn’t how today’s markets work. The original formula was foundational, the way the Wright brothers’ first flight was foundational to aviation—but nobody flies a 1903 Flyer across the Atlantic today.
Modern pricing systems, built by teams of mathematicians and quants at major trading firms, account for things the original model handles imperfectly: changing volatility, early exercise, dividend schedules, liquidity, and sudden price jumps. Each firm’s model is a closely guarded trade secret, since even small pricing improvements can be worth millions across thousands of daily trades.
Although far more sophisticated than the original equation, these models 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 one of the most commonly misunderstood concepts in options trading: implied volatility. We’ll cover it in Part 2 of this series.
*****
A Beginner’s Guide to Option Pricing: Complete Series Index
1. A Beginner’s Guide to Option Pricing – Part 1 (Theoretical Value)
https://www.philstockworld.com/2026/07/11/who-decides-what-an-option-is-worth/
2. A Beginner’s Guide to Option Pricing – Part 2 (Implied Volatility)
https://www.philstockworld.com/2026/07/12/who-decides-what-an-option-is-worth-part-2/
3. A Beginner’s Guide to Option Pricing – Part 3 (Thinly Traded Options)
https://www.philstockworld.com/2026/07/12/a-beginners-guide-to-option-pricing-part-3/
4. A Beginner’s Guide to Option Pricing – Part 4 (Liquid Options)
https://www.philstockworld.com/2026/07/13/a-beginners-guide-to-option-pricing-part-4/
5. A Beginner’s Guide to Option Pricing – Part 5 (Put-Call Parity)
https://www.philstockworld.com/2026/07/14/a-beginners-guide-to-option-pricing-part-5/
6. A Beginner’s Guide to Option Pricing – Part 6 (Delta)
https://www.philstockworld.com/2026/07/15/a-beginners-guide-to-option-pricing-part-6-delta/
7. A Beginner’s Guide to Option Pricing – Part 7 (Gamma)
https://www.philstockworld.com/2026/07/15/a-beginners-guide-to-option-pricing-part-7-gamma/
8. A Beginner’s Guide to Option Pricing – Part 8 (Theta)
https://www.philstockworld.com/2026/07/16/a-beginners-guide-to-option-pricing-part-8-theta/
9. A Beginner’s Guide to Option Pricing – Part 9 (Vega)
https://www.philstockworld.com/2026/07/17/a-beginners-guide-to-option-pricing-part-9-vega/
