Are option prices whimsical?
Presumably, as in stocks, option prices are dictated by laws of supply and demand. If the same assumption is valid for options, especially standard options, how does one reconcile that set-up with a bid-and-ask price scenario of 0.5 to 9.75, i.e., a spread of 9.25?
PS: The underlying security is not thinly traded, by any stretch of the imagination.
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With a B/A that wide, there are no buyers or sellers offering to trade at better prices.
There are a number of reasons that wide a spread could happen....
You may be looking at bad provider data.
It could be right after the market's opening and the option rotation hasn't opened so the quote is ka-ka.
News may be pending (for example, release of clinical trials) and the spread has widened while the world waits to see where the underlying is going to land.
Without knowing the underlying price as well as the strike price and whether it's a put or call, it's just guesswork.
Options are derivatives and so their price is derived from their underlying market. For stock options the price of the options are derived from the fluctuating price of the underlying stock.
Market makers will make a market for an illiquid option when a price is entered near the true value of the option (determined by how much time to expiry, how far into or out of the money, the underlying share price and various other factors).
Supply and demand of the actual option only comes into play when the option is very liquid and traded often. For illiquid options you will need to rely on the market maker and the supply and demand of the underlying.
Supply and demand is a generally good economic theory about price determination but bid/ask spreads depend more on risk and liquidity than supply and demand. In your example, supply and demand sets the (average) price of 5.125 but the spread is relatively large 9.25 because the risk to the market maker when setting this bid/ask is likely very large.
As D Stanley, mentions the market for options is much thinner than the underlying so the market maker is much less certain of the price and needs to protect herself from this uncertainty by using a large spread. In addition, since the type of buyer/seller of options tends to be more knowledgeable and the risk and payouts can be much larger the market maker must protect herself even further.
However, I would go a step farther and say that the price for many options is actually only loosely driven by supply and demand. Pricing for many options tends to be done more or less by formula because in many cases the underlying markets are extremely thin and knowing certain information about the underlying can help reasonably price an option. Interestingly, these formula tend to be fairly accurate even though pricing models for the underlying stock itself tend to be much harder to use successfully.
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