Binomial Option Pricing Model

Binomial option pricing is a simple but powerful technique that can be used to solve many complex option-pricing problems. In contrast to the Black-Scholes and other complex option-pricing models that require solutions to stochastic differential equations, the binomial option-pricing model (two state option-pricing model) is mathematically simple. It is based on the assumption of no arbitrage.

So in essence, the binomial option pricing model assumes a perfectly efficient market. Under this assumption, it is able to provide a mathematical valuation of an option at each point in the timeframe specified. The binomial model takes a risk-neutral approach to valuation and assumes that underlying security prices can only either increase or decrease with time until the option expires worthless.