Binomial Option Pricing Model: Understanding and Application

The binomial option pricing model is a complicated formula for pricing options. The binomial model is based on two possible outcomes using combination mathematics to reiterate the number of outcomes in the model.The model is used with the help of a computer spreadsheet to calculate the price of an option.

The benefits of using the model include a reasonable method to pricing options as well as a basis to calculate their value. Some of the drawbacks to the binomial pricing model are that it emphasizes the model on two possible outcomes, essentially up or down movements in the market. Another drawback is that the pricing model is difficult to calculate if not with the help of a spreadsheet. Another model commonly used is the black-scholes model which is even more complicated. Research has shown the binomial pricing method as being more accurate for pricing options that are outside of the market's price range.

There is one other method as well which is taking a simple subtraction of the market price with the exercise price, make the calculation a lot easier. This intrinsic value method leaves one only to estimate the time value of the option.