A Beginner’s Guide to Option Pricing
Part 3 – Pricing Dynamics: Infrequently Traded Options vs. Highly Liquid Options
A Real-World Example Using Veeva Systems (VEEV)
In Part 1, we discussed the difference between an option’s theoretical value—estimated by sophisticated pricing models—and its market price, determined by what buyers and sellers are actually willing to pay. In Part 2, we explained how implied volatility represents the market’s estimate of future uncertainty, and how every option’s price splits into intrinsic value and time value.
Now let’s see how these ideas play out in the real world. One of the biggest differences between option markets is liquidity. Some options trade hundreds of thousands of contracts every day, while others may trade only a few dozen contracts, or even none at all.
Understanding that difference is one of the keys to understanding option pricing.
The Role of Market Makers
Imagine there were no market makers.
Suppose you wanted to sell a call option. You enter your order and wait. Perhaps another investor wants exactly that option at exactly that moment. Perhaps not.
For many stocks, especially those whose options trade only lightly, there may simply be no one willing to take the other side of your trade. In some cases, no one has traded that particular contract yet that day, so there’s no established quote at all until a market maker steps in to create one.
Without someone ready to buy and sell, the options market would become slow, inefficient, and sometimes barely function at all.
That is where market makers come in. Companies such as Citadel Securities, Jane Street, Susquehanna, IMC, Wolverine, and Optiver, among others, devote enormous resources to making markets in stocks and options.
Their business is providing liquidity. Think of them as wholesalers. Their job is to stand ready to buy from investors who want to sell, and sell to investors who want to buy, allowing trades to occur quickly instead of forcing everyone to wait for another investor with the opposite opinion.
Without market makers, many option contracts would rarely—or never—trade.
How Market Makers Determine Their Prices
So how does a market maker decide what price to quote?
The starting point is the theoretical value we discussed in Part 1. Using sophisticated pricing models descended from Black-Scholes, the market maker estimates what the option should be worth based on the current stock price, time remaining until expiration, interest rates, dividends, and implied volatility.
Suppose the model estimates that an option has a theoretical value of $3.50. Does that mean the market maker will immediately sell it for exactly $3.50? No. Like any business, the market maker must be compensated for taking on risk.
Instead, the quotes might look something like this:
- Bid: $3.40
- Ask: $3.60
An investor wishing to sell immediately can sell to the market maker for $3.40. An investor wishing to buy immediately can purchase it for $3.60.
The difference between those prices—the bid-ask spread—is one of the primary ways market makers are compensated for providing liquidity. Every option they buy or sell exposes them to risk, and the spread provides a financial cushion against that uncertainty.
Why Some Options Have Tiny Spreads and Others Have Much Wider Spreads
When an option trades continuously throughout the day—that is, when it’s highly liquid—market makers know they can usually offset their positions very quickly. Their risk is relatively low, so bid-ask spreads tend to be narrow, sometimes only a penny or two.
Now imagine an option that trades only a handful of contracts during an entire trading day.
If you want to buy or sell that option, a market maker will typically take the other side of your trade. That’s the market maker’s function. But who will buy the option from them, or sell it to them, when they need to offset that position?
Maybe someone later this afternoon. Maybe next week. Maybe no one.
The market maker may have to hold that position for a while as the stock price, implied volatility, and overall market conditions keep changing. That added uncertainty increases their risk, so they compensate by quoting wider bid-ask spreads.
Experienced option traders often look at the spread before almost anything else. A narrow spread suggests many buyers and sellers are actively competing. A wide spread often suggests the market is relatively thin and that market makers are playing a larger role in providing liquidity.
When the Crowd Takes Over
Sometimes an option becomes extraordinarily popular. Thousands of investors begin buying and selling.
At that point, the market maker is no longer the only important participant — the crowd begins influencing prices. The pricing models still provide a starting point, but now supply and demand become much more important. Option prices begin reflecting not only mathematics but also the collective opinions of thousands of investors.
This distinction is one of the most important concepts in options trading. In a relatively quiet market, pricing models and market makers exert most of the influence. In an extremely active market, the crowd becomes an equally important force.
The Three Forces Behind Every Option Price
By now we can see that every option price reflects the interaction of three different forces.
The first is mathematics. Sophisticated pricing models estimate the option’s theoretical value using the stock price, time remaining until expiration, interest rates, dividends, and implied volatility.
The second is the market makers. They continuously update quotes based on those theoretical values while managing their own inventory and risk.
The third is the marketplace itself. Every time investors rush to buy or sell options, they push prices toward whatever buyers and sellers are actually willing to pay.
Sometimes these three forces produce prices that are almost identical. Sometimes they don’t. Recognizing which force is dominating at any given moment is one of the most valuable skills an option trader can develop.
Putting Theory into Practice: Veeva Systems (VEEV)
Let’s see how these ideas appear in an actual option chain.
On Friday, July 10, Veeva Systems (VEEV) closed at $190.12. We’ll examine the options expiring one week later, on July 17.
VEEV is an excellent teaching example because, unlike companies such as NVIDIA, its options market is relatively quiet. The stock itself trades actively enough, but the options do not attract enormous speculative activity.
Looking at the $190 strike, we find the following quotes.
The $190 call was quoted approximately:
- Bid: $4.30
- Ask: $5.10
Only 28 contracts traded that day, while open interest stood at 599 contracts.
The $190 put was quoted approximately:
- Bid: $4.00
- Ask: $4.80
Only 23 contracts traded during the session, with open interest of 156 contracts.
Those numbers immediately tell an options trader several things.
First, the market is relatively quiet. Twenty-eight call contracts and twenty-three put contracts for an entire day is not much activity — in a very active options market, that many contracts might trade in only a few seconds.
Second, notice the 80-cent bid-ask spreads on both the calls and the puts. Those are much wider than you’d expect in an actively traded option chain.
Why? Because the market maker cannot assume another investor will immediately appear to take the opposite side of the trade. If the market maker buys your option today, they may still own it tomorrow. During that time, the stock price could move, implied volatility could change, or overall market conditions could shift. The wider spread compensates them for accepting that additional risk.
As likely the only counterparty available, the market maker effectively dictates the pricing — buying near the low end of the range and selling near the high end. That’s the market maker’s business model.
Now notice something else interesting. Although VEEV closed almost exactly at the $190 strike price, the calls and puts are not perfectly symmetrical.
- The calls are quoted between $4.30 and $5.10.
- The puts are quoted between $4.00 and $4.80.
Many beginning investors expect those prices to be identical, but they almost never are.
Part of the difference is easy to explain: the stock closed 12 cents above the strike price, giving the call a small amount of intrinsic value while leaving the put slightly out of the money.
But that explains only a small part of the difference. The remainder reflects everything we’ve discussed in this series: implied volatility, the market maker’s pricing model, inventory management, interest rates, and ordinary supply and demand.
Because relatively few investors are actively trading VEEV options, there are fewer market participants pushing prices away from the market maker’s theoretical estimates. The pricing models don’t determine the market price by themselves, but in quieter markets they exert much greater influence — simply because there are fewer competing buyers and sellers to move prices away from what the market maker, as counterparty, is willing to accept.
In other words, when you look at VEEV’s option chain, you’re seeing a market where the first two forces—pricing models and market makers—are doing most of the work. The third force, supply and demand from the investing public, may be present, but it’s comparatively modest.
Looking Ahead
VEEV actually represents the kind of options market most investors encounter. Thousands of publicly traded companies have listed options, but relatively few attract the extraordinary trading activity of companies like NVIDIA, Tesla, Apple, or the SPDR S&P 500 ETF (SPY).
In Part 4, we’ll examine NVIDIA’s option chain and see what happens when hundreds of thousands of option contracts trade every day. There, we’ll discover that the balance of power shifts dramatically. The pricing models are still there, and market makers still provide liquidity, but the sheer weight of buying and selling by investors becomes a much larger influence on option prices.
Only after seeing both VEEV and NVIDIA side by side can you fully appreciate how the same pricing principles produce very different-looking option markets. That’s a fascinating aspect of options trading—and one of the least understood by beginning investors.
