Can someone kindly elaborate how option pricing works in practice/reality. Let's take FX as an example. Say I trade EUR/USD options and sales people come to me and ask me to make prices for different strikes for different tenors. Imagine that I get a request from a salesperson. She/he is asking me to quote a 3 month ATMF strike. How do I figure out what the implied volatility should be? Do I look at the realised/delivered volatility over the past 3 month window in conjunction with the forward-looking economic/event calendar and come up with the estimate for implied volatility? Or do I just ask my favourite broker for a price and go with that? How do I figure out how wide my price should be? Should I show 1 volatility point wide or maybe 0.5? Thanks a million!

supply and demand, however, it depends on how many players exist. That is why experience is a valuable quantity. I suggest you tell your sales guy to get as much as he can. Seriously, you will need to get some sort of implied vol,  RR and BF quotes from your broker and use that to construct a smile. Generally yopur price should be the cost of hedging internally + some vega premium

Thanks doublebarrier2000! Is this to say that the starting points for curve construction are the IV, RR and BF quotes one can retrieve from the brokers? If so this might result in some sort of herding behaviour among market makers (you and me might talk to the same broker and therefore use the same building blocks)? How would you determine a sufficient vega premium? Would you estimate how long you might have to warehouse the risk and how much the surface might move within that 'warehousing window'? Whilst you warehouse one would probably replicate/hedge the exposure?

It is very difficult to predict what will happen in the Forex market since you mention many interesting aspects of the analysis, and touch on important points, I will add something that you have to consider, this is referring to the value of a pip where we have to assess the risk to take in each operation and the spread that the broker charges you for the trade. which also alters the yield curve.

You start with where the market is based on broker quotes and in periods of relative calm all you do is adjust around that based on your flow...it gets more interesting when you go in to events for example

If you are a market maker processing 100-1000 transactions a day, then the "herding behaviour among" market agents is not a risk for you. You buy/sell just to dispose of your position 15 minutes later. You can do it because you are trading a very liquid product: a vanilla option on the most liquid cross (EUR/USD).
If you are a prop trader planning to warehouse the position at least for a while, that is a different story. Your model must incorporate all the issues you have mentioned and many others... Still, to determine your bid-ask you start at the market bid-ask and make yourself competitive on the right side.