Binomial Option Pricing Model: Basics

Binomial trees can be used to price options when the Black-Scholes and other continuous-time approaches cannot be applied. We describe the basics of pricing options using the binomial tree by discussing up and down states at discrete time intervals and demonstrate how a binomial tree is constructed. We then look at extending the number of nodes on a binomial tree, and finish up by looking at the principle of risk neutrality and its role in calculating price probabilities.