Binomial Option Pricing Model – 5 Advantages and Disadvantages

Last updated on April 27th, 2023 at 03:03 am

Are you looking for what is the BOPM – Binomial Option Pricing Model? AAMcourses is here to help you with your search. In this article, we will discuss the meaning of the Binomial Option Pricing Model, the Binomial tree, and the advantage and disadvantages of the Binomial Option Pricing Model. 

The BOPM: Binomial Option Pricing Model is a simple-to-understand model for pricing option contracts. This model helps investors and traders to analyze their stock options. The BOPM model helps them to understand the value of underlying assets which helps traders to change and improve their strategies.

Introduction to the Binomial Option Pricing Model

The Binomial Option Pricing Model was introduced in 1979 by Cox, Ross, and Rubinstein. Therefore, The BOPM model is also known as the “Cox-Ross-Rubinstein Pricing Model” or the CRR Model.

The BOPM – “Binomial Option Pricing Model represents the price movement for the underlying asset in a tree form known as the binomial tree.”

The BOPM helps us determine the price of an option based on the characteristics of the underlying asset or the stocks. According to this model, the options follow a binomial distribution system, i.e., the price of the underlying assets can only fluctuate in one direction by a specific amount.

The BOPM works on the key assumption that only two possible outcomes are possible for a particular stock. The stock prices will either go up or go down.

ALSO READ ABOUT : The 4 Most Effective Option Strategies You Should Know

Assumptions of the Binomial Option Pricing Model

• No return on underlying assets
• There is no change in the risk-free rate.
• The result for price fluctuation is binomial, i.e., two outcomes.
• Traders are risk neglecters, and they don’t take much risk.
• Interest remains constant.

Binomial Tree

The Binomial Tree is a visual representation tool used to show the Binomial Option Pricing Model visually.

In Binomial Tree, a stock price tree is drawn in the forward form at every point in time. This tree is called a binomial tree. According to the Binomial tree, the underlying asset can have only values in the next period.

Advantages of the Binomial Option Pricing Model

• The BOPM provides a detailed summary of the underlying asset’s price for a specific period.
• The model provides us with an accurate and clearer value of the option.
• It helps investors to study the price fluctuations of the underlying asset at different times. It helps to determine various possibilities for its future price movement.
• The BOPM is much easier than the Black-Scholes Model as it only assumes two possible outcomes.
• The BOPM facilitates checking the options anytime before their expiry.

Disadvantages of the Binomial Option Pricing Model

• The process for BOPM is simple yet complex in the calculation.
• It takes time to process complex computations, which increases the time taken to calculate the value of the option.
• BOPM is not possible when there are a lot of possible outcomes because of the long time process.
• BOPM requires future prices as an input to work.
• One of the main disadvantages of the BOPM model is that the market forces are more accurate and reliable for understanding option value than BOPM calculations.

ALSO READ ABOUT : What is Volatility in Stock Market ? 2 Important Types and Measures used for Understanding Volatility

FAQs

Closing Statement

The Binomial Option Pricing Model is an option pricing model that helps to determine the future value of the option. This allows investors to make a more precise and sound decision with much more confidence. The binomial tree is a visual representative tool that helps to interpret the BOPM visually.

I hope this article about the Binomial Option Pricing Model is informative. If you have any doubts or suggestions, write them in the comment box.