How options are priced

Options pricing can seem mysterious at first, why does one option cost $4 and another similar one costs $1.50? The answer comes down to a set of well-understood inputs that collectively determine an option's fair value. Understanding these inputs won't just help you interpret option prices, it will fundamentally change how you think about every trade you make.

The Black-Scholes model

The foundation of modern options pricing is the Black-Scholes model, developed in 1973 by Fischer Black, Myron Scholes, and Robert Merton. While more sophisticated models are used by professional traders today, Black-Scholes captures the core logic of how the six primary inputs interact to produce an option's theoretical price.

You don't need to understand the mathematics, but you need to understand the inputs.

The six inputs that determine options price

1. Current stock price The higher the stock price, the more expensive calls are and the cheaper puts are (all else equal). As the stock rises, ITM calls gain intrinsic value. As it falls, ITM puts gain intrinsic value.

2. Strike price Determines moneyness. ITM options are more expensive than OTM options. ATM options carry the most extrinsic value.

3. Time to expiration More time = more premium. The stock has more time to make a favorable move, so the option's probability of becoming profitable is higher. This is what theta erodes every day, the value of remaining time.

4. Implied volatility The most influential input after the stock price itself. Higher IV = more expensive options across all strikes. IV reflects the market's expectation of future movement, uncertainty is priced into options as extrinsic value.

5. Risk-free interest rate Rising interest rates increase call values and decrease put values slightly (measured by rho). For short-dated options this effect is minimal. For long-dated options like LEAPS, it's more significant.

6. Dividends Expected dividends reduce call values and increase put values. When a stock pays a dividend, the stock price drops by the dividend amount on the ex-dividend date, reducing the value of calls and benefiting puts.

How the inputs interact

The table below summarizes how each input affects call and put prices:

Notice that implied volatility and time to expiry affect both calls and puts in the same direction. This is because both inputs increase uncertainty, and uncertainty makes all options more valuable.

What the model can't capture

Black-Scholes makes several assumptions that don't hold perfectly in real markets:

• Constant volatility: In reality, IV changes constantly (and varies by strike, volatility skew)
• Normal distribution of returns: Real markets have "fat tails", extreme moves happen more often than the model predicts
• No early exercise: Black-Scholes assumes European-style exercise; American-style options with early exercise potential require adjustments

These imperfections are why professional traders use more sophisticated models and why there's always a gap between theoretical and market prices.

Theoretical price vs market price

Options don't always trade at their theoretical Black-Scholes value. Market forces, supply and demand, sentiment, hedging activity, liquidity, push market prices above or below theoretical values.

The most common and systematic divergence is volatility skew: OTM puts consistently trade at higher IV than OTM calls of the same distance, reflecting persistent demand for downside protection.

Implied volatility is essentially the market's adjustment: When you solve Black-Scholes backwards, plugging in the market price and solving for the volatility that would produce it, you get implied volatility. IV is what the market is implying about future movement.

Practical takeaways

• High IV = expensive options → better to sell
• Low IV = cheap options → better to buy
• More time to expiry = more expensive options
• ATM options carry the most extrinsic value, most to gain or lose from IV and time changes
• Deep ITM options are mostly intrinsic value, less sensitive to IV and theta

Related terms: Implied volatility, intrinsic value, extrinsic value, theta, vega, delta, Black-Scholes

Try it on Stryke: See live option pricing across all strikes and compare IV levels in the Options Screener.

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