Model

In trading, a model is a mathematical formula or set of calculations that takes known inputs and produces an estimate of something you can't observe directly — most commonly, what an option "should" be worth. Instead of guessing at a fair price, a trader plugs numbers into the model and lets the math produce a theoretical value.

For options, the typical inputs are the current stock price, the strike price (the price at which the option lets you buy or sell the stock), how much time is left until expiration, an estimate of how much the stock is expected to swing around (volatility), any dividends the stock is expected to pay before expiration, and a risk-free interest rate (roughly, the return on a safe asset like short-term government debt). The model combines these into a single theoretical price for the option. The Black-Scholes model is the best-known example, though there are others built for different situations, such as options on futures or American-style options that can be exercised early.

The nuance that trips people up is that a model's output is only as good as its inputs, and one input — volatility — isn't actually known in advance; it has to be estimated. Traders often run the model backwards, taking the option's current market price and solving for the volatility number that would justify it. That derived figure is called implied volatility, and it's frequently more useful in practice than the model's forward-looking price estimate. It's also worth remembering that a model is a simplification: it assumes things like continuous trading and no sudden jumps, which real markets don't always deliver.

Because of this, model prices are a reference point, not a guarantee. Traders compare a model's theoretical value to the actual market price to judge whether an option looks cheap or expensive relative to the model's assumptions, not relative to some absolute truth.