What is a Tree Diagram

A tree diagram is a diagram used in strategic decision making, valuation or probability calculations. The diagram starts at a single node, with branches emanating to additional nodes, which represent mutually exclusive decisions or events. In the diagram below, the analysis will begin at the first blank node. A decision or event will then lead to node A or B. From these secondary nodes, additional decisions or events will occur leading to the third level of nodes until a conclusion is reached.

Example of a tree diagram.


A tree diagram allows a user start at a single point and make mutually exclusive decisions or experience mutually exclusive events to follow a path down the branches of the tree. Using the tree diagram is simple once you assign the appropriate values to each node. Chance nodes, representing a possible outcome, must be assigned a probability. Decision nodes ask a question and must be followed by answer nodes, such as "yes" or "no." Often, a value will be associated with a node, such as a cost or a payout. Tree diagrams combine the probabilities, decisions, costs and payouts of a decision and provide a strategic answer. The price of an option such as a put or call can be modeled using a decision tree given the price of the underlying security at a given point in time.