Next the buyers are coming because they realize the option is underpriced relative to expected stock's move. The market makers realize that too based on rising volume and rising actual volatility of the stock. They adjust the option quote based on the market's expected future volatility and their theoretical model so the theoretical ( set by market makers) price of options gets in line with what market thinks it should be. I am saying that at any point in time the theoretical price is equal to market price as it was at time 0 ( no buyers and sellers). Right?
That makes sense... I'm just curious then... couldn't a MM provide a market for options that is technically overpriced? When I look at BRK.B, that's how I would interpret them. Even though HV is low, IV tells me that MM's are asking for way too much. So what you're saying is, HV and IV both determine Theoretical price, since the MM will provide a market based on an opinion, and the market will have an opinion, and Supply/Demand will settle at a price where the collective will have a forecast on where the underlying will move....
I would say that theoretical options price is calculated based on IV ( and is equal to the current market price). http://en.wikipedia.org/wiki/Implied_volatility
If people want to get out (sell) of their position, that creates supply. If people want to take positions, that creates demand (buying). But don't assume that demand for calls means up. It's like the open interest argument. Lots of calls were bought. Was that person bullish or were they hedging a short stock position? I find much of this HV, IV, FV discussion (in books) to be circular. Well, at least the IV/FV part since HV is just a measure of the past. . Forecasted volatility is an estimate of the future volatility of the underlying whereas is implied volatility is determined by the pricing model (tho its amount depends on the pricing model) and reflects the market's general consensus of forecasted volatility. It's almost redundant. AFAIK, much of it is outside the realm of practical reality. How many retail traders here are finding and capitalizing on over/under valued options? I doubt many.
OP, I recommend you to actually go back to the basics. Having read the past 6 pages I claim 70% of all posters and posts are factual at least partially incorrect. If you really want to learn about volatility then you should learn to answer the following questions first, and you can google to find answers, but at least you have done your own homework instead of having read incorrect answers: *** What does HV measure? *** what is the underlying instrument of HV? The option itself or the underlying of the option? *** How to generate the return series which are used to calculate HV? *** Why do some people use log returns? *** Why do some people omit the mean when calculating HV? *** How to scale HV from one time period to another and why is it done that way? *** What is the underlying instrument of IV? *** Over what horizon is IV exactly expressed? *** How do IV and HV reconcile? Why do some market practitioners relate those two against each other? If you are able to correctly answer all those questions then you can move on to some basic options pricing model. Believe me, most posters who participated cannot answer those questions correctly (as evidenced by their incorrect comments) dont mean to put others down but there are some serious errors in previous statements which show the most basic understanding is lacking...
Let's see: You come to me and you say I am willing to buy from you OTM call option for $3 ( You've calculated that volatility today is let's say 20% and you are going to make good money on this trade because the price WILL make a move greater than $3 before expiration). But I tell you that I expect volatility to rise to let's say 25% before the expiration and $3 is too cheap and I'll sell you for $5 ( Remember options are 0 sum game). You scratch your head and we both agree that volatility is going to rise and we come up with what we think is a fair price(which should be above $3). As you see the past volatility is irrelevant for options pricing. Does it make any sense?
Asiaprop, i'm ok hearing I'm wrong. It's the only way I'll learn. (if any of that was directed at me).