Binomial option pricing model: what is it?

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The binomial option pricing model is a method of determining the value of an option contract, a contract that gives the owner the exclusive opportunity to buy or sell some asset for an agreed price over a predetermined period of time. This model is useful to investors because it is difficult to determine the value of an options contract, which is based on the price of some underlying instrument. Also, the Binomial Option Pricing Model, or BOPM, is especially useful for US options, which can be exercised any time before the expiration date. A typical BOPM is set up like a tree, with the original price leading to two prices, which leads to three, and so on.

Option contracts provide investors the opportunity to speculate on the price of an underlying security without actually obtaining physical ownership of the asset. Since the value of the contract is based on the value of the underlying asset at some point in the future, it is difficult for an investor to assess the value of the contract at the time of purchase. One method of projecting option prices into the future is the binomial option pricing model, which can determine a set of possible values ​​for a contract, based on the prices of the underlying asset, from inception to expiration.

For the binomial option pricing model to be successful, one must be able to measure an asset’s volatility, which is the degree to which the price of the underlying asset can change within a limited time frame. As an example, imagine that an asset has a current price of $100 US dollars (USD) and has a volatility level of 20 percent. That means that the price of the asset for the second period judged by the BOPM would be $120 USD if the price goes up, or $80 USD if the price goes down.

In the next step, these two prices would be broken down further based on volatility to produce three more possible prices for the next period. In BOPM’s characteristic branching structure, three possible prices would divide into four, and so on for the duration of the option. This allows investors to make very specific predictions about the possible future prices of their assets.

Another benefit of the binomial option pricing model is that it can be adjusted to reflect anticipated changes based on the probability that a price will go up or down. In the example above, it was assumed that there was a 50 percent chance that the price would go up and a 50 percent chance that it would go down in the second period. But in the next period, those percentages could be affected by the price changes that an asset usually takes. The BOPM can account for this.

In addition to providing a good option pricing model, the binomial option pricing model can help US option holders decide when to exercise those options. If the BOPM showed that potential future prices for an underlying asset are exceptionally high, an investor might want to hold the option. On the other hand, prices that spiral downward in the model could cause the investor to exercise the option at its maximum value.

Smart Asset.

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