13/12/2019 Binomial Option Pricing Model Definition

PART OF
Options Trading Guide

OPTIONS & DERIVATIVES TRADING OPTIONS TRADING STRATEGY & EDUCATION

Binomial Option Pricing Model

REVIEWED BY MARSHALL HARGRAVE | Updated Sep 12, 2019

TABLE OF CONTENTS
Binomial Option Pricing
Basics of the Binomial Pricing
Calculating w/the Binomial Model
Real World Example
EXPAND +

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.

https://www.investopedia.com/terms/b/binomialoptionpricing.asp 1/9
13/12/2019 Binomial Option Pricing Model Definition

PART OF
Options Trading Guide

KEY TAKEAWAYS
The binomial option pricing model values options using an iterative approach
utilizing multiple periods to value American options.
With the model, there are two possible outcomes with each iteration—a move up or
a move down that follow a binomial tree.
The model is intuitive and is used more frequently in practice than the well-known
Black-Scholes model.

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:

https://www.investopedia.com/terms/b/binomialoptionpricing.asp 2/9
13/12/2019 Binomial Option Pricing Model Definition

PART OF
Options Trading Guide

Basics of the Binomial Option Pricing Model

With binomial option price models, the assumptions are that there are two possible
outcomes, hence the binomial part of the model. With a pricing model, the two outcomes
are a move up, or a move down. The major advantage to a binomial option pricing model is
that they’re mathematically simple. Yet these models can become complex in a multi-period
model.

https://www.investopedia.com/terms/b/binomialoptionpricing.asp 3/9
13/12/2019 Binomial Option Pricing Model Definition

In contrast to the Black-Scholes model, which provides a numerical result based on inputs,
the binomial
PART OFmodel allows for the calculation of the asset and the option for multiple
Options
periods Trading
along with Guide
the range of possible results for each period (see below).

The advantage of this multi-period view is that the user can visualize the change in asset
price from period to period and evaluate the option based on decisions made at different
points in time. For a U.S-based option, which can be exercised at any time before
the expiration date, the binomial model can provide insight as to when exercising the option
may be advisable and when it should be held for longer periods. By looking at the binomial
tree of values, a trader can determine in advance when a decision on an exercise may occur.
If the option has a positive value, there is the possibility of exercise whereas, if the option has
a value less than zero, it should be held for longer periods.

Calculating Price with the Binomial Model

The basic method of calculating the binomial option model is to use the same probability
each period for success and failure until the option expires. However, a trader can
incorporate different probabilities for each period based on new information obtained as
time passes.

https://www.investopedia.com/terms/b/binomialoptionpricing.asp 4/9
13/12/2019 Binomial Option Pricing Model Definition

A binomial tree is a useful tool when pricing American options and embedded options. Its

simplicity is its advantage and disadvantage at the same time. The tree is easy to model out
mechanically,
PART OF but the problem lies in the possible values the underlying asset can take in
Options
one period time.Trading Guidetree model, the underlying asset can only be worth exactly
In a binomial
one of two possible values, which is not realistic, as assets can be worth any number of
values within any given range.

For example, there may be a 50/50 chance that the underlying asset price can increase or
decrease by 30 percent in one period. For the second period, however, the probability that
the underlying asset price will increase may grow to 70/30.

For example, if an investor is evaluating an oil well, that investor is not sure what the value of
that oil well is, but there is a 50/50 chance that the price will go up. If oil prices go up in
Period 1 making the oil well more valuable and the market fundamentals now point to
continued increases in oil prices, the probability of further appreciation in price may now be
70 percent. The binomial model allows for this flexibility; the Black-Scholes model does not.

Binomial Tree

Binomial Tree.

https://www.investopedia.com/terms/b/binomialoptionpricing.asp 5/9
13/12/2019 Binomial Option Pricing Model Definition

Real World Example of Binomial Option Pricing Model

A simplified example of a binomial tree has only one step. Assume there is a stock that is
pricedPART
at $100
OF per share. In one month, the price of this stock will go up by $10 or go down
by $10,Options
creatingTrading Guide
this situation:

Stock price = $100

Stock price in one month (up state) = $110
Stock price in one month (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 one-half 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 risk-free rate over the
course of the month. The cost today must be equal to the payoff discounted at the risk-free
rate for one month. The equation to solve is thus:

Option price = $50 - $45 x e ^ (-risk-free rate x T), where e is the mathematical constant
2.7183.

Assuming the risk-free 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—
which can be executed anytime between the purchase date and expiration date. It is also
much simpler than other pricing models such as the Black-Scholes model.

https://www.investopedia.com/terms/b/binomialoptionpricing.asp 6/9
13/12/2019 Binomial Option Pricing Model Definition

Related Terms
Lattice-Based
PART OF
Model
Options Trading Guide
A lattice-based model is a model used to value derivatives; it uses a binomial tree to show different
paths the price of the underlying asset may take. more

How the Black Scholes Price Model Works

The Black Scholes model is a model of price variation over time of financial instruments such as
stocks that can, among other things, be used to determine the price of a European call option. more

Option Pricing Theory Definition

Option pricing theory uses variables (stock price, exercise price, volatility, interest rate, time to
expiration) to theoretically value an option. more

Trinomial Option Pricing Model

The trinomial option pricing model is an option pricing model incorporating three possible values
that an underlying asset can have in one time period. more

Binomial Tree
A binomial tree is a graphical representation of possible intrinsic values that an option may take at
different nodes or time periods. The value of the option depends on the underlying stock or bond.
more

Boolean Algebra
Boolean algebra is a division of mathematics which deals with operations on logical values and
incorporates binary variables. more

Partner Links

https://www.investopedia.com/terms/b/binomialoptionpricing.asp 7/9
13/12/2019 Binomial Option Pricing Model Definition

Related
PART Articles
OF
Options Trading Guide
ADVANCED OPTIONS TRADING CONCEPTS
Breaking Down The Binomial Model To Value An Option

ADVANCED OPTIONS TRADING CONCEPTS

Understanding the Binomial Option Pricing Model

ADVANCED OPTIONS TRADING CONCEPTS

Circumventing the Limitations of Black-Scholes

FINANCIAL ANALYSIS
Using Decision Trees in Finance

ADVANCED OPTIONS TRADING CONCEPTS

How to Build Valuation Models Like Black-Scholes

OPTIONS TRADING STRATEGY & EDUCATION

The Anatomy of Options

https://www.investopedia.com/terms/b/binomialoptionpricing.asp 8/9
13/12/2019 Binomial Option Pricing Model Definition

TRUSTe
PART OF
Options
Terms Trading
of Use Guide Contact Us News
Advertise Dictionary Careers

Investopedia is part of the Dotdash publishing family.

The Balance | Lifewire | TripSavvy | The Spruce and more

https://www.investopedia.com/terms/b/binomialoptionpricing.asp 9/9