This computational model uses an iterative procedure, allowing for the specification of nodes during the time between the valuation date and the option’s expiration date. At each node, the model assumes the underlying asset can move to one of two possible prices, creating a binomial tree. By working backward from the option’s expiration value at each final node and applying a risk-neutral probability at each step, the model determines the option’s theoretical value at the initial node. A simple example could involve a stock that might either increase or decrease by a certain percentage at each step. The model calculates the option’s payoff at each final node based on these price movements and then works backward to determine the current option price.
Its strength lies in its ability to handle American-style options, which can be exercised before expiration, unlike European-style options. Furthermore, it can accommodate dividends and other corporate actions that impact the underlying asset’s price. Historically, before widespread computational power, this method provided a practical alternative to more complex models like the Black-Scholes model, especially when dealing with early exercise features. It remains a valuable tool for understanding option pricing principles and for valuing options on assets with non-standard characteristics.
