Who Decides What an Option Is Worth? Part 2

At the end of Part 1, we saw that pricing models can estimate what an option should be worth using factors like stock price, strike price, time, and volatility.

But one of those inputs is much harder to pin down than the others.

Nobody knows how much a stock will actually move between now and next week, next month, or six months from now. So how does a pricing model come up with a number for something nobody can know?

The answer lies in one of the most misunderstood concepts in investing: implied volatility, often abbreviated as IV.

Many investors hear that phrase dozens of times before they understand what it actually means. Fortunately, the basic idea is much simpler than most textbooks make it sound.

Options Are Really About Uncertainty

Many beginners think option prices are simply a bet on direction — that a call is priced based on how likely the stock is to go up, and a put is priced based on how likely it is to go down.

That’s understandable, and it’s not entirely wrong. If you buy a call, you’re very possibly betting the stock rises. If you buy a put, you’re very possibly betting it falls. Professional traders take directional views constantly — that’s the entire reason strategies like bull call spreads or bearish put positions exist.

But direction is the trader’s view. It’s not what the option pricing model is actually built on.

The model pricing the option — the one determining whether that call costs $2 or $8 — doesn’t know or care whether you think the stock is going up. It’s answering a different question:

How much might this stock move, in either direction, before the option expires?

That’s a question about magnitude — how far, not which way. And the pricing model answers it the same way whether the buyer on the other side of the trade is bullish, bearish, or has no opinion at all.

Imagine two companies.

Both are trading at exactly $100.

The first company hardly ever moves. Most weeks it rises or falls by only one or two dollars.

The second company is wildly unpredictable. It might gain $20 in a week. It might lose $20.

Which company’s options should be more expensive?

Almost everyone would answer the second one because there is much more uncertainty about how far the stock might travel — regardless of which direction it goes.

A call option on the second company has a much greater chance of becoming very valuable. A put option also has a much greater chance of becoming very valuable.

In other words, both calls and puts become more expensive when future price movements become more uncertain, independent of whether the market leans bullish or bearish on the stock.

Notice something important: a trader can have a strong directional opinion and still be pricing — and paying for — something that has nothing to do with that opinion.

The direction is the trade. The magnitude of expected movement is the price.

That distinction, between what you believe will happen and what you’re actually paying for, is one of the biggest conceptual shifts new option investors need to make.

Every Option’s Price Has Two Separate Ingredients

Before we go further, we need to split an option’s price into two pieces.

This is one of the most useful things to know about options. Every option’s price is made up of two components:

Intrinsic value.

Time value (also called extrinsic value).

Intrinsic value is the simple part. It’s how much the option would be worth if you had to exercise it right now, today, this second.

Suppose a stock is trading at $105. A call option with a strike price of $100 lets its owner buy the stock for $100.

Since the stock is worth $105, that right is worth at least $5 right now.

That $5 is intrinsic value. It doesn’t depend on the future at all. It’s simply today’s stock price compared with the strike price.

Now suppose that same option is trading for $7.

Where did the other $2 come from? That’s time value.

Time value represents the uncertainty about where the stock might go before the option expires. It’s the price of possibility.

An option with a lot of time remaining before expiration, on a stock that moves around a great deal, will typically carry a lot of time value.

An option about to expire, on a stock that barely moves, will carry very little.

When we talked earlier about uncertainty driving option prices, we were talking specifically about time value.

While the intrinsic value tracks the stock, the time value is the part of the price that reflects uncertainty. It’s the part that shrinks as expiration approaches — a process called “time decay.”

An option can also have no intrinsic value at all.

If our $100 strike call existed while the stock was trading at $95, exercising it would mean paying $100 for something worth $95. Nobody would do that.

So the intrinsic value in that case is zero.

Yet the option would still have a price — because there’s still time left before expiration, and the stock could still rise back above $100 before then.

That entire price would be time value — pure uncertainty, with nothing else behind it.

This matters because implied volatility is a statement about time value, not intrinsic value. Implied volatility is the market’s way of pricing uncertainty, and uncertainty, as we now know, is exactly what time value measures.

With the split between intrinsic value and time value now clear, we can look at where implied volatility actually comes from. It comes from the same place all prices come from: people buying and selling — only here, what they’re really trading is their collective guess about how much uncertainty a stock deserves.

Imagine You’re the Insurance Company

Here’s an analogy that makes implied volatility more concrete. Imagine you’re in the business of selling homeowners insurance. Two houses are worth exactly the same amount. The first house sits beside a quiet lake in a peaceful neighborhood. The second sits halfway up an active volcano.

Would you charge both homeowners the same insurance premium? Of course not.

The volcano house carries much greater uncertainty. You don’t know whether it will erupt. But you know there is a greater chance something dramatic could happen. Therefore, you charge more — not because you know something will happen, but because you can’t rule it out.

Options work exactly the same way: the marketplace prices in more for a stock that could erupt than for one that stays quiet.

Volatility Is Not the Same as Risk

This is another point that confuses many beginners.

When professionals talk about volatility, they are not making a judgment about whether a company is good or bad.

Volatility simply measures how much prices tend to move. A wonderful company can have volatile stock. A struggling company can have relatively stable stock.

Volatility isn’t measuring quality. It’s measuring movement.

Think of driving.

A straight interstate highway may be perfectly safe and very predictable.

A winding mountain road may also be perfectly safe, but you’ll spend far more time turning the steering wheel.

The mountain road has greater variability.

Stocks are the same way. Some travel in relatively smooth paths. Others swing wildly from week to week. Options become more expensive on roads with more twists and turns.

Historical Volatility and Implied Volatility Are Different Things

There are actually two kinds of volatility, and confusing them is one of the most common mistakes new option traders make.

Historical volatility looks backward. It asks, “How much has this stock actually moved over the past month or year?” That’s simply a measurement of history.

Implied volatility looks forward. It asks, “How much movement does today’s option market appear to be expecting?”

Historical volatility is like looking through the rear-view mirror. Implied volatility is like looking through the windshield.

Here’s why the difference matters: it’s how traders judge whether an option looks cheap or expensive. If implied volatility is running well above a stock’s historical volatility, options are pricing in more drama than the stock has actually shown recently — which may mean the market expects something (an earnings report, a court ruling, a Fed meeting) to shake things up. If implied volatility is running below historical volatility, options may be underpricing risk relative to how the stock has actually behaved. Comparing the two is one of the simplest ways to get a read on whether options are currently priced richly or cheaply.

One practical note: on a real option chain, implied volatility is displayed as an annualized percentage — something like “32% IV” — rather than a dollar figure. That percentage is a standardized way of expressing “how much movement the market expects,” so it can be compared across different stocks and expiration dates, and against a stock’s own historical volatility.

Here’s the Part That Almost Everyone Gets Backwards

Here’s one of the most important ideas in options pricing: implied volatility isn’t an input traders plug into a model to get a price. It’s the reverse.

The marketplace works in the opposite direction. First, buyers and sellers trade options. Those trades establish market prices. Only afterward do traders ask:

“If today’s option is selling for this price, what level of future volatility would make our pricing model produce that same number?”

The answer is implied volatility.

Notice what happened.

The market price came first. Implied volatility was discovered afterward. It wasn’t measured directly. It was implied by the market price. That’s why the number is called implied volatility.

Why Market Makers Care So Much About Implied Volatility

Now let’s return to the market maker. Imagine you work for a large trading firm. A customer wants to buy an option. How much should you charge?

If you expect the stock to move only one dollar over the next month, you’ll quote one price.

If you expect it could move twenty dollars, you’ll quote a much higher price.

Expected movement changes everything. This is why implied volatility becomes the common language of the options market.

Instead of saying, “I think this stock will probably move about twelve dollars before expiration,” professionals discuss implied volatility.

Once everyone speaks that common language, pricing models can convert those expectations into theoretical option values.

Do Market Makers Use Black-Scholes?

The answer is both yes and no. The original Black-Scholes equation changed finance forever, but today’s market makers rarely rely on that exact 1973 formula.

Instead, they use much more sophisticated descendants that incorporate decades of additional research.

Different firms use different models. Most of those models are proprietary and closely guarded. No firm wants its competitors to know exactly how it prices options.

However, they all begin with the same basic idea. Estimate future uncertainty. Then use mathematics to estimate what the option should be worth.

The models themselves do not create the market price. They estimate a theoretical value.

The actual trading price still depends on what buyers and sellers are willing to pay.

If Everyone Has a Pricing Model, Why Don’t All Options Trade at Exactly the Same Price?

Suppose several market makers all estimate that an option’s theoretical value is about $3.50. Will it necessarily trade at $3.50? No.

Imagine a rare vintage guitar heading to auction. Several instrument experts estimate it’s worth about $40,000. But two collectors who’ve wanted that exact model for decades show up to bid, and the auction closes at $58,000.

Were the experts wrong? Not necessarily — their estimate reflected what the guitar should be worth under normal conditions. The final price reflected how badly two particular buyers wanted it that day. The appraisal and the sale price answered two different questions.

Options work the same way. Theoretical value is a starting point; the marketplace sets the final price. That’s why options can temporarily trade above or below what even sophisticated pricing models estimate — competition pulls prices back toward theoretical value quickly in liquid markets, but in thinly traded options, prices can drift further since there are fewer participants to close the gap.

The Foundation for Everything That Follows

By now we’ve covered a lot of ground. Pricing models estimate an option’s theoretical value. Every option’s price splits into intrinsic value and time value, with time value being the part driven by uncertainty. The market reveals that uncertainty through implied volatility. And actual trading prices are still determined by buyers, sellers, and market makers — not by a mathematical equation alone.

These ideas form the foundation for understanding every option chain you’ll ever see.

In Part 3, we’ll examine a real option chain from a relatively quiet stock. We’ll see how market makers use these ideas to quote prices when there are relatively few buyers and sellers, why bid-ask spreads become much wider, and why call and put prices often look surprisingly different even when trading activity is minimal.

Once you understand that quieter market, we’ll examine one of the busiest option markets in the world—NVIDIA—and see how thousands of competing buyers and sellers can influence prices in ways that simply don’t occur in less active stocks.