Binomial Option Model
An options pricing model that builds a discrete-time tree of possible asset prices to derive the fair value of an option.
What is Binomial Model?
The binomial option pricing model, developed by Cox, Ross, and Rubinstein in 1979, values options by constructing a binomial tree of possible underlying asset price movements over discrete time steps. At each node, the asset price can move up or down by a specified factor, and the probability of each move is calibrated to the asset's volatility. Working backward from the option's payoff at expiration to the present using risk-neutral pricing, the model calculates a fair value at each node. The binomial model is especially useful for pricing American-style options (which can be exercised early) and options on dividend-paying stocks, cases where Black-Scholes is less tractable.
Example
An investor prices a 2-step binomial tree for a call option on a stock currently trading at $100 with a strike of $105, expiring in two periods. At each step the stock rises 10% or falls 10%. Working backward from the terminal payoffs using the risk-neutral probability, the model produces a fair value of approximately $5.80 for the call — providing a cross-check against the Black-Scholes formula.
Source: CFA Institute — Derivatives and Alternative Investments