does bid and ask volume affect option price

Question

I have been trying to figure out how option pricing works and so far my understanding is as follows:

There are few methods to determine the option price, Black-Scholes method is one of them. However, this method uses current stock price, the intrinsic value, time to expiration or the time value, volatility, interest rates, and cash dividends paid. I don't see anything about the actual bid and ask volume of the option itself. I would expect the price to go down if there is a large supply. What am I missing?

Answer 1

Volume has nothing to do with option pricing but it does affect price. What does that mean?

An option's theoretical price is determined by the price of the underlying, the strike price, the time remaining until expiration, volatility, the carry cost (interest rate), and cash dividends (if any). The intrinsic value has nothing to do with it because that is merely a function of the relationship of the strike price to the underlying's price.

However, the market is an auction and price is affected by supply and demand. The higher the demand (more buy volume than sell volume), the higher the price. And conversely, the lower the demand, the lower the price. The mere fact that there is a limit order (maker not taker liquidity) to buy (bid) or sell (ask) X contracts at the current quote is meaningless.

Answer 2

The bid size and ask size is an indication of how many contracts are available to be sold at that price on the market.

Some exchanges use a model called pro-rata sizing, where if you have 3 market makers offering 100 contracts at the same price, and an order comes in to buy 9 contracts, the order would be split into 3 pieces and executed against the other market makers on a pro-rata basis - i.e. each would get 3 of the shares executed. As a result, it encourages market makers to quote large quantities, and generally inflates the size available. I think if you actually asked the market makers if they actually wanted to actually trade 100 contracts, they would probably say 'no'. You can hold them to the offer, but they wouldn't like it, and for them, it probably doesn't happen so often.

Other exchanges offer price-time priority, where the market maker (or participant) who posted their price first is the first one to get executed. They will generally have smaller sizes but the sizes would more genuinely reflect the quantities the market maker wished to trade. This model encourages participants to be more aggressive on price.

If someone wants to sell a lot of options, the act of selling will push the prices down, rather than the offering of a large quantities. Those market makers who wanted to buy would decrease their quotes as their appetite to buy the option dries up and the prices would subsequently decrease. It would likely be a much smaller quantity than the sizes would indicate.