Binomial Option Pricing
Candlefocus EditorThe binomial model for valuing options is more intuitive than the more established Black-Scholes model. Plus, it offers investors the advantage of being able to value American options (options that can be exercised at any time prior to expiry) more accurately.
To begin the binomial process, an investor would start by assessing the current market conditions, to establish the asset's present value. By progressing through subsequent periods, they can then assess what the up and down-side price movements are likely to be, before reaching the option's expiration date. During each iteration, the investor must make assumptions regarding the volatility of the market, as well as the expected rate of return.
The return from each iteration of the binomial approach is then used to calculate a value for each possible future outcome. These two values are then combined to establish a base value for the option. Through subsequent parent and child node calculations, the investor is able to establish the present value of the option, based on the expected future outcomes.
The advantages that the binomial approach offers investors include the ability to accurately value American options and its versatility in assessing options with differing expiry dates and unknown volatilities. Such a method of pricing options can also help investors gauge the effect of any change in market conditions. As such, it is an efficient way of assessing complex derivatives.
In conclusion, the binomial option pricing model is a valuable tool for valuing American options. By utilizing iterative calculations, an investor is able to accurately compute the current market value of an option, based on its expected future outcomes. In addition, the model offers investors the advantage of being able to assess the effect of any change in market conditions on their portfolios.