Why Trading Volume Is Not an Option Pricing Input
Summary
The document asks whether option prices should incorporate trading volume, especially when an option position is large but the underlying moves on little volume. It suggests that a volume-weighted underlying price near expiration might better capture intrinsic value and the liquidity cost of exercising or closing a position.
The response explains that standard option models generally omit volume because the contractual payoff and probability of finishing in the money do not depend on trading activity. Liquidity can still affect market quotes: it may be reflected to some degree in implied volatility and particularly in the spread between implied volatility quotes. Wider spreads are expected when the underlying is illiquid or when uncertainty, such as an upcoming dividend decision, is high. The discussion offers this conceptual distinction between payoff valuation and trading liquidity, but no quantitative method for adjusting option prices or measured evidence.
Key ideas
- Standard option valuation models generally do not use trading volume as an input.
- For ordinary options, volume does not determine the contingent payoff or the chance of finishing in the money.
- Underlying liquidity may be reflected in implied volatility quotes and their spreads.
- Illiquid underlyings and uncertainty around events such as dividends can widen implied volatility spreads.
- The document gives no specific formula for a volume-based option price adjustment.
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Full text
# options pricing using vwap # options pricing using vwap This is a question about why options prices do not take volume into account. The popular option valuation formula "black-scholes" certainly does not account for this and I don't suggest that it does. But one could hold a large option position while the underlying asset's price walks up or down on very low volume, allowing the option to gain more and more value and be liquidated without affecting the market for the underlying asset. This seems strange to me, since it would seem to me that the option's value/price should have a liquidity premium for exercising the option and closing the position on the underlying asset, despite the fact that most options are not exercised. I like the inefficiencies in option pricing, as a speculative tool and the predictability in calculating intrinsic value as an in the money option moves deeper in the money. But it seems that volume weighted price nearer expiration should determine the price of an option's intrinsic value in the black-scholes formula Thoughts and insight appreciated ## Answer by Matt Wolf (score 5) https://quant.stackexchange.com/a/8592 As you correctly pointed out volume has no place in the pricing models of most any option(Unless of course you create an option whose underlying or is volume in some way or if volume is used as some sort of barrier). The reason is simple: The contingent payoff and hence the probability of ending up in the money is not a function of volume. Why the market is perfectly comfortable with that fact, including those who hedge the option with underlying assets is because liquidity is priced into the implied volatility directly to some degree but it is especially priced into the implied vol spread. Should the underlying be highly illiquid or should, for example a highly uncertain dividend declaration loom, then spreads in the quoted implied vols will widen. This can easily be seen when you compare options on underlying assets that are highly liquid with much turnover vs options whose underlying rarely trades.
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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.