What is the relationship between price and market?
Although the fair value may be close to where the market is trading, other pricing factors in the market place mean fair value is used mostly as an estimate of the option’s value. Moreover, fair value will depend on the assumptions regarding volatility levels, dividend payments and so on that are made by the person using the pricing model. Different expectations of volatility or dividends will alter the fair value result.
This means that at any one time there may be many views held simultaneously on what the fair value of a particular option is. In practice, supply and demand will often dictate at what level an option is priced in the marketplace. Traders may have a fair value on an option to get an indication of whether the current market price is higher or lower than fair value, as part of the process of making a judgment about the market value of the option.
Volatility:
The volatility figure input into an option-pricing model reflects the assumptions of the person using the pricing model. Volatility is defined technically in various ways, depending on assumptions made about the underlying asset’s price distribution. For the regular option trader it is sufficient to know that the volatility a trader assigns to a stock reflects expectations of how the stock price will fluctuate over a given period of time.
Volatility is usually expressed in two ways- historical and implied. Historical volatility describes volatility observed in a stock over a given period of time. Price movements in the stock (or underlying asset) are recorded at fixed time intervals (for example every day, every week, or every month) over a given period. More data generally leads to more accuracy. Implied volatility relates to the current market for an option.
Volatility is implied from the option’s current price, using a standard option-pricing model. Keeping all other inputs constant, you can put the current market price of an option into any theoretical option price calculator and it will calculate the volatility implied by that option price.
