I understand that option prices are based on various factors, most importantly, underlying’s price, time left for expiry, and implied volatility.
If it so, then the option price should be pure function of mathematical formula alone rather than traders deciding the price by entering ask and bid prices, like in normal stocks. Why do we have this concept and how this thing factors in price calculation?
I guess the answer would also explain why sometimes if the value of underlying is decreasing fastly and suddenly stops, the call prices shoot up little bit, which should not happen unless the movement is upside.
Its because of main element in the system ie: People( Buyer-seller). Its the people making decision kind of a voting machine in short term ( traders) that derive value . Options are just contracts so let say there are many buyers and less sellers so seller will ask for higher premiums and vice versa. Its due to demand supply. Just trade Sensex or Midcp nifty you will really feel these push pull effect
Okay, but if it’s based on people’s decision, then why do OTMs always reach 0 on expiry?
If people are deciding, then there would be at least one case where option strike pricing would be out of order like any OTM would be significantly higher than 0 or a case where NIFTY 19800 CE would have higher price than NIFTY 19700 CE at the time of expiry when NIFTY is trading at around 19850ish
The premiums on the options are entirely dependent on the auction. The theoretical linkage ensures the HFTs and algos define the range, but the final price is decided by supply/demand.
If you observe few OTM strikes, you can even see a slippage from theoretical values. This is where the arbitrageurs play their game.
PS: I personally like to find these mispriced options and trade them. For this to happen the level of uncertainty has to rise mostly measured by a rising VIX
This may never happen, because 19700 has a higher intrinsic value than 19800 CE when nifty is at 19850. Its because 19700 is more in the money than 19800. A look at the option chain will give you more clarity!
Say if someone wants to buy 10000000000000 Rs of a single strike. Someone has to supply that much for transaction to happen right ? And others may want to put their tiny order ahead of him perhaps etc etc. Things are dynamic always.
Demand and supply comes first, and usually it will be in sync with theory as markets are efficient enough and there is arbitrage opportunity if they are not.
