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Why Option Model Prices Can Differ from Market Quotes

Article Quant Q&A · Author: Nikunj Guna
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Summary

The document considers whether an option should be sold when its market quote falls below a Black–Scholes estimate. Its main guidance is to treat the discrepancy as a prompt to investigate assumptions and inputs, rather than as evidence that the option is mispriced. A model may be incorrect, or it may express a subjective valuation that differs from a risk-neutral price implied by the market. Taking a position on that gap means accepting the risk that the trader’s view is wrong.

The answer also points to market-data quality as a possible explanation. An option quote may be stale or the contract may be illiquid, especially for far out-of-the-money options; in that setting, the ask may be less informative than the bid. The discussion is conceptual and does not identify the specific inputs behind the example price, diagnose its model, or offer a method for determining fair value. It cautions against treating a model-market gap alone as a sell signal, without providing empirical evidence that any particular trading rule is profitable.

Key ideas

  • A gap between a model valuation and a market quote does not by itself establish mispricing.
  • A risk-neutral model price and a trader’s subjective valuation represent different views of value.
  • Model assumptions and inputs should be checked when the estimate differs from the market.
  • Stale quotes and illiquidity can make prices for far out-of-the-money options unreliable.
  • A trade based on a valuation gap carries the risk that the model or subjective view is wrong.

Tags

OptionsDerivatives pricingRisk management
Full text
# Difference Between Option market price and Theoretical price?


# Difference Between Option market price and Theoretical price?












So I am working on strategies that depends on the difference between Actual market price of option and price derived using black and scholes model. For eg: Spot 19000 , strike 19200 . It is OTM call option where market price is 50. But using Model price is 57.20. That means price is at 7.2 discount. So people are less interested in this so, sell this OTM strike. Is this valid view ? Or Am I missing something ?. Can anyone please elaborate why there is difference between these two prices and what do difference mean and how can we use it ?

## Answer by Frido (score 3)

https://quant.stackexchange.com/a/76449

Welcome to the world of options.

First and foremost rule of the game, you should imprint it:

The market is right, you are wrong.

This may seem absurd, but it's not. At least for the first ten years or so, until you are far more experienced in the game, you should always remember the rule.

What does this mean about your model: that either it is wrong, or that you are comparing your subjective views and prices to so-called risk-neutral prices (which are the closest thing to objective prices).

If it's the latter, that's OK in the sense that you are prepared to take a risk on the difference between your subjective view and the risk-neutral price.

But if your model is a risk-neutral price and does not match the market price, then you should try to find where you made the error.

Another possibility is the option price you are looking at is stale and/or very illiquid. For far OTM options you should not always trust ask prices, bid prices are probably more reliable.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.