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.

Down Transition Probability
The probability that an asset's value will decline in one period's ... 
Fugit
The amount of time that an investor believes is left until it ... 
Stock Option
A privilege, sold by one party to another, that gives the buyer ... 
Option Premium
1. The income received by an investor who sells or "writes" an ... 
Call On A Put
One of the four types of compound options, this is a call option ... 
Exotic Option
An option that differs from common American or European options ...

Trading
Breaking Down The Binomial Model To Value An Option
Find out how to carve your way into this valuation model niche. 
Trading
Basics Of The Binomial Distribution
Despite the fancysounding name, you already understand the Binomial Distribution, and you can use it to make money. Ready? Read on. 
Trading
The Anatomy of Options
Find out how you can use the "Greeks" to guide your options trading strategy and help balance your portfolio. 
Trading
Getting Acquainted With Options Trading
Learn more about stock options, including some basic terminology and the source of profits. 
Trading
How to Build Valuation Models Like BlackScholes
Want to build a model like BlackScholes? Here are the tips and guidelines. 
Trading
Circumventing the Limitations of BlackScholes
Learn the ways to get around the flaws in trading models like BlackScholes.

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 >> 
When is a call option considered to be "in the money"?
Learn about call options, their intrinsic values and why a call option is in the money when the underlying stock price is ... Read Answer >>