Binomial Option Pricing Model

What is the 'Binomial Option Pricing Model'

The binomial option pricing model is 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.

BREAKING DOWN '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.

  1. Lattice-Based Model

    An option pricing model that involves the construction of a binomial ...
  2. Down Transition Probability

    The probability that an asset's value will decline in one period's ...
  3. American Option

    An option that can be exercised anytime during its life. American ...
  4. Expiration Time

    A specified time, after which the options contract is no longer ...
  5. Bjerksund-Stensland Model

    A closed-form option pricing model used to calculate the price ...
  6. Black's Model

    A variation of the popular Black-Scholes options pricing model ...
Related Articles
  1. Options & Futures

    Options Pricing: Cox-Rubenstein Binomial Option Pricing Model

    The Cox-Rubenstein (or Cox-Ross-Rubenstein) binomial option pricing model is a variation of the original Black-Scholes option pricing model. It was first proposed in 1979 by financial economists/engineers ...
  2. Options & Futures

    Using Decision Trees In Finance

    These decision-making tools play an integral role in corporate finance and economic forecasting.
  3. Fundamental Analysis

    Examples To Understand The Binomial Option Pricing Model

    Binomial option pricing model, based on risk neutral valuation, offers a unique alternative to Black-Scholes. Here are detailed examples with calculations using Binomial model and explanation ...
  4. Options & Futures

    The Anatomy of Options

    Find out how you can use the "Greeks" to guide your options trading strategy and help balance your portfolio.
  5. Options & Futures

    Options Pricing: Modeling

    Option traders utilize various option price models to attempt to set a current theoretical value. Models use certain fixed knowns in the present – factors such as underlying price, strike ...
  6. Options & Futures

    Exploring European Options

    The ability to exercise only on the expiration date is what sets these options apart.
  7. Options & Futures

    Circumvent Limitations of Black-Scholes Model

    Mathematical or quantitative model-based trading continues to gain momentum, despite major failures like the financial crisis of 2008-09, which was attributed to the flawed use of trading models. ...
  8. Options & Futures

    Getting Acquainted With Options Trading

    Learn more about stock options, including some basic terminology and the source of profits.
  9. Options & Futures

    Options Pricing: A Review Of Basic Terms

    The following is intended as a review of basic option terminology, which can be used as a reference as needed: American Options - An option that can be at any point during the life of the contract. ...
  10. Options & Futures

    Give Yourself More Options With Weekly and Quarterly Options

    Weekly and quarterly options were introduced to give a greater choice of option expirations to investors, and enable them to trade more efficiently.
  1. What is the average return on equity for a company in the electronics sector?

    Learn about the Black-Scholes option pricing model and the binomial options model, and understand the advantages of the binomial ... Read Answer >>
  2. How is implied volatility for options impacted by a bearish market?

    Learn why implied volatility for option prices increases during bear markets, and learn about the different models for pricing ... Read Answer >>
  3. Can an option be exercised on the expiration date?

    The use of options has increased dramatically over the years as a way to profit from or hedge against the volatile movements ... Read Answer >>
  4. How do I change my strike price once the trade has been placed already?

    Learn how the strike prices for call and put options work, and understand how different types of options can be exercised ... Read Answer >>
  5. How are call options priced?

    Learn how aspects of an underlying security such as stock price and potential for fluctuations in that price, affect the ... Read Answer >>
  6. Do you have to be an expert investor to trade put options?

    Learn about investing in put options and the associated risks. Explore how options can provide risk, which is precisely defined ... Read Answer >>
Hot Definitions
  1. White Squire

    Very similar to a "white knight", but instead of purchasing a majority interest, the squire purchases a lesser interest in ...
  2. MACD Technical Indicator

    Moving Average Convergence Divergence (or MACD) is a trend-following momentum indicator that shows the relationship between ...
  3. Over-The-Counter - OTC

    Over-The-Counter (or OTC) is a security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, ...
  4. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis for the reporting of earnings and the paying of dividends.
  5. Weighted Average Cost Of Capital - WACC

    Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is ...
  6. Basis Point (BPS)

    A unit that is equal to 1/100th of 1%, and is used to denote the change in a financial instrument. The basis point is commonly ...
Trading Center