How does the OCC price options???

[KevinS]

I am aware that the price of an option = intrinsic value + some mysterious time value, + or - the bid-ask spread so that the OCC or exchange (which one, actually?) can make a profit. My question is: how are the prices set?

Here are the answers I think are most likely:
A. Time Value is a set formula
B. The prices are set so that approximately half is buyers and half are sellers

I think both are equally likely. Formulas because they are regulated and half buyers/sellers because this would limit any losses realized by the exchange/OCC.

I do know that options are priced based on stocks and likely any information you can provide that I didn't ask for, so please don't waste your time if you do not know the answer or a link that can provide it. Thanks!

[zman492]

I agree with StopSpending that the OCC does not set option prices. Prices are set by the market. If there are more sell orders than buy orders being submitted, prices go down. If there are more buy orders than sell orders being submitted, prices go up.

Neither the DPMs (Designated Primary Market Makers) nor the other market makers directly determine option prices unless there are no other buyers or sellers willing to better the market makers quotes.

As far as I know, the only place where DPMs have more influence on prices than other market makers is that DPMs determine when there is a "fast market" condition. When there is a fast market declared, the market makers do not have to follow the normal restrictions on the maximum difference between the market makers' bid and ask quotes.

Although you may well already know this, let me pause for a moment and discuss what a market maker does. A market maker is an option trader, much like any other individual or firm that trades options. A market maker has one major responsibility that other traders do not have. A market maker must supply a bid quote and an ask quote for every option traded on the underlying issue. So if you are a market maker for IBM options, you have to have both buy and sell limit orders outstandng for every IBM option that exists. This makes you a liquidity provider. A market maker also has one major advantage over other traders. A market maker is the first to see new orders coming in and, if the order cannot be filled immediately electronically, has the first chance to fill incoming orders.

Because market makers may have thousands of contracts outstanding on any given underlying issue, they have to offset their risks. The risk associated with a small change in the price of the underlying security, known as delta risk, can be offset by taking long or short positions in the underlying security. Certain other risks can only be offset with other options positions. So, as a rule, market makers want to have roughly the same number of long positions as short positions at any given time. If they find themselves with more long positions than short positions, they lower their quotes hoping to get buy orders from potential buyers. Similarly, if they find themselves with more short positions than long positions, they raise their quotes to get more sell orders from potential sellers. So you are correct that in general market makers try to set their prices so there are an equal number of buyers and sellers.

It is also accurate to say that "Time Value is a set formula." Market makers do not go through every option for a given underlying and decide how to price each quote. Instead, they determine what implied volatility (IV) they want to use and let a computer figure out what prices to use for quotes. The IV of an option, along with other variable such as strike price and amount of time until expiration, can be fed into a formula to determine the price of an option.

It is important that all options for one underlying security, particularly all options expiring an a given month, have the same (or almost the same) IV. If the IV varies too much arbitrage opportunities will arise. It is worth noting that a the same IV is used for both puts and calls. So, if some large fund submits an order to buy 2,000 calls on a fairly thinly traded stock, that will raise the IV which in turn will raise the price of both the calls and the puts.

[StopSpending]

The OCC doesn't price options. They clear them. They do have to worry about valuation, though, because they provide the risk models for determining margin. From the link below, they use a complicated scenario analysis to determine margin.

Exchanges don't determine prices either. They provide a mechanism for buyer and sellers to meet and transact. There are members of the exchange who provide bid and offer prices. (On the CBOE, they are called DPMs.); however, prices are ultimately determined by the demand and supply in the marketplace which can be based upon views on the stock or views on the future distribution of stock returns.