Binomial Option Pricing Model

AAA

DEFINITION of 'Binomial Option Pricing Model'

An options valuation method developed by Cox, et al, in 1979. The binomial option pricing model uses an iterative procedure, allowing for the specification of nodes, or points in time, during the time span between the valuation date and the option's expiration date.

The model reduces possibilities of price changes, removes the possibility for arbitrage, assumes a perfectly efficient market, and shortens the duration of the option. Under these simplifications, it is able to provide a mathematical valuation of the option at each point in time specified.

INVESTOPEDIA EXPLAINS 'Binomial Option Pricing Model'

The binomial model takes a risk-neutral approach to valuation. It assumes that underlying security prices can only either increase or decrease with time until the option expires worthless. A simplified example of a binomial tree might look something like this:

Binomial Option Pricing Model



Due to its simple and iterative structure, the model presents certain unique advantages. For example, since it provides a stream of valuations for a derivative for each node in a span of time, it is useful for valuing derivatives such as American options which allow the owner to exercise the option at any point in time until expiration (unlike European options which are exercisable only at expiration). The model is also somewhat simple mathematically when compared to counterparts such as the Black-Scholes model, and is therefore relatively easy to build and implement with a computer spreadsheet.

RELATED TERMS
  1. Lattice-Based Model

    An option pricing model that involves the construction of a binomial ...
  2. Tree Diagram

    A diagram used in strategic decision making, valuation or probability ...
  3. Efficient Market Hypothesis - EMH

    An investment theory that states it is impossible to "beat the ...
  4. Expiration Date (Derivatives)

    The last day that an options or futures contract is valid. When ...
  5. Heath-Jarrow-Morton Model - HJM ...

    A model that applies forward rates to an existing term structure ...
  6. Black Scholes Model

    A model of price variation over time of financial instruments ...
Related Articles
  1. thinkstock|istock
    Options & Futures

    Breaking Down The Binomial Model To Value An Option

    Find out how to carve your way into this valuation model niche.
  2. Options & Futures

    Getting To Know The "Greeks"

    Understanding price influences on options positions requires learning about delta, theta, vega and gamma.
  3. Options & Futures

    Options Basics Tutorial

    Discover the world of options, from primary concepts to how options work and why you might use them.
  4. Options & Futures

    Employee Stock Options (ESO)

    Employee stock options are a form of equity compensation granted by companies to their employees and executives.
  5. Bonds & Fixed Income

    Accounting and Valuing Employee Stock Options

    Learn the different accounting and valuation treatments of ESOs, and discover the best ways to incorporate these techniques into your analysis of stock.
  6. Options & Futures

    What are the most common momentum oscillators used in options trading?

    Read about some of the most common technical momentum oscillators that options traders use, and learn why momentum is a critical concept for options trading.
  7. Options & Futures

    How are Bollinger BandsĀ® used in options trading?

    Use Bollinger Bands to identify volatility changes and place options trades at the right time; profit in bull or bear markets using these strategies.
  8. Options & Futures

    Stock Futures vs Stock Options

    A full analysis of when is it better to trade stock futures vs when is it better to trade options on a particular stock. A quick overview of how each of them works and why would a trader, investor, ...
  9. Options & Futures

    The Potential Of Low-Priced Options

    The benefits of trading low-priced options, and learning how to pinpoint them, can be a very profitable strategy for an options trader.
  10. First time stock investors may ask, is there any way to buy insurance on stocks to prevent losses?
    Options & Futures

    Stock Safety: Top 3 Ways to Limit Your Losses

    First time stock investors may ask, is there any way to buy insurance on stocks to prevent losses?

You May Also Like

Hot Definitions
  1. Commodity

    1. A basic good used in commerce that is interchangeable with other commodities of the same type. Commodities are most often ...
  2. Deferred Revenue

    Advance payments or unearned revenue, recorded on the recipient's balance sheet as a liability, until the services have been ...
  3. Multinational Corporation - MNC

    A corporation that has its facilities and other assets in at least one country other than its home country. Such companies ...
  4. SWOT Analysis

    A tool that identifies the strengths, weaknesses, opportunities and threats of an organization. Specifically, SWOT is a basic, ...
  5. Simple Interest

    A quick method of calculating the interest charge on a loan. Simple interest is determined by multiplying the interest rate ...
  6. Special Administrative Region - SAR

    Unique geographical areas with a high degree of autonomy set up by the People's Republic of China. The Special Administrative ...
Trading Center