Definition
Theoretical value is the price an option pricing model calculates as fair, given the current inputs: the underlying price, the strike, time to expiration, volatility, interest rates, and any dividends. The best known such model is Black-Scholes.
The theoretical value is a benchmark, not a guarantee. The market price — the premium — can sit above or below it, and that gap is information a trader can act on.
Why it matters
How it works
A pricing model takes the observable inputs and produces a single fair-value number. Most inputs are known; volatility is the exception, since future volatility cannot be observed. Traders either feed in an estimate of expected volatility or work backward from the market price to find the implied volatility the market is pricing in. If a quoted premium is well below theoretical value, the option may be a buy; if well above, a sell. The Greeks — delta, theta, vega and others — are derivatives of this same model, each describing how the theoretical value shifts when one input moves.