What is the 'Binomial Option Pricing Model'
The binomial option pricing model is an options valuation method developed 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, and removes the possibility for arbitrage. A simplified example of a binomial tree might look something like this:
BREAKING DOWN 'Binomial Option Pricing Model'
The binomial option pricing model assumes a perfectly efficient market. Under this assumption, it is able to provide a mathematical valuation of an option at each point in the timeframe specified. The binomial model takes a riskneutral approach to valuation and assumes that underlying security prices can only either increase or decrease with time until the option expires worthless.Binomial Pricing Example
A simplified example of a binomial tree has only one time step. Assume there is a stock that is priced at $100 per share. In one month, the price of this stock will go up by $10 or go down by $10, creating this situation:
Stock Price = $100
Stock Price (up state) = $110
Stock Price (down state) = $90
Next, assume there is a call option available on this stock that expires in one month and has a strike price of $100. In the up state, this call option is worth $10, and in the down state, it is worth $0. The binomial model can calculate what the price of the call option should be today. For simplification purposes, assume that an investor purchases onehalf share of stock and writes, or sells, one call option. The total investment today is the price of half a share less the price of the option, and the possible payoffs at the end of the month are:
Cost today = $50  option price
Portfolio value (up state) = $55  max ($110  $100, 0) = $45
Portfolio value (down state) = $45  max($90  $100, 0) = $45
The portfolio payoff is equal no matter how the stock price moves. Given this outcome, assuming no arbitrage opportunities, an investor should earn the riskfree rate over the course of the month. The cost today must be equal to the payoff discounted at the riskfree rate for one month. The equation to solve is thus:
Option price = $50  $45 x e ^ (riskfree rate x T), where e is the mathematical constant 2.7183
Assuming the riskfree rate is 3% per year, and T equals 0.0833 (one divided by 12), then the price of the call option today is $5.11.
Due to its simple and iterative structure, the binomial option pricing 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. It is also much simpler than other pricing models such as the BlackScholes model.

Option Pricing Theory
An option pricing theory is any model or theorybased approach ... 
LatticeBased Model
A latticebased model is a model used to value derivatives; it ... 
Exotic Option
An exotic option is more complex or has a different structure ... 
Listed Option
A listed option is a derivative security traded on a registered ... 
Underlying Option Security
An underlying option security is the financial instrument (stock, ... 
Vanilla Option
A vanilla option gives the holder the right to buy or sell an ...

Investing
Examples To Understand The Binomial Option Pricing Model
Binomial option pricing model, based on risk neutral valuation, offers a unique alternative to BlackScholes. Here are detailed examples with calculations using Binomial model and explanation ... 
Trading
The "True" Cost Of Stock Options
Perhaps the real cost of employee stock options is already accounted for in the expense of buyback programs. 
Investing
Why Options Trading Is Not for the Faint of Heart
Trading options is not easy and should only be done under the guidance of a professional. 
Trading
Circumventing the Limitations of BlackScholes
Learn the ways to get around the flaws in trading models like BlackScholes. 
Trading
Beginners Guide To Options Strategies
Find out four simple ways to profit from call and put options strategies. 
Trading
Option trading strategies: A guide for beginners
Options offer alternative strategies for investors to profit from trading underlying securities. Learn about the four basic option strategies for beginners. 
Trading
Understanding Option Pricing
Before venturing into the world of trading options, investors should have a good understanding of the factors determining the value of an option.

When holding an option through expiration date, are you automatically paid any profits, ...
Holding an option through the expiration date without selling does not automatically guarantee you profits, but it might ... Read Answer >> 
How can derivatives be used to earn income?
Learn how option selling strategies can be used to collect premium amounts as income, and understand how selling covered ... Read Answer >> 
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 >> 
How Do Speculators Profit From Options?
Options are a risky game, but you can learn speculators' tricks to use them to your advantage. Read Answer >>