Option Pricing - Where does it come from?

Option pricing, or insurance, is a relative value product. For instance, a $300 annual premium for $1 million of life insurance coverage for a young, healthy individual is reasonable. However, that same $300 price tag to insure a 65 year-old heavy smoker with high blood pressure is way too cheap.

When it comes to life insurance, the concept of ‘risk’ can be defined as any possible event that could lead to the insurer making a pay-out. This risk can be estimated by looking at past historical evidence that speaks to how risk played-out for a similar individual. Life insurance underwriters look at a person’s propensity for events such as injury, illness and death. They then assign an appropriate premium and spread that risk across many individuals. What they are really doing is looking at something option traders call historical volatility, or ‘risk’ for a typical individual of that age and health.

In option markets, risk is simply the ‘risk of movement’. In this context, think of the risk of a stock moving through a strike being similar to the risk of an individual falling very ill (being healthy or being ill straddling the ‘strike price’). Both have consequences for the insurer and both need to be assigned a probability and value: that is your option cost!

Both insurers and options traders are looking at historical volatility to gauge this past risk in order to assign an appropriate level of option pricing to that risk.