Binomial Tree

  

A yes-no, up-down, high-low case representation for outcomes, usually as applied to the investing in derivative securities.

Like..."if IBM's quarter is good, then the call option is likely worth x; if IBM's quarter is bad, then the call option is likely worth x over 100."

The whole idea behind a binomial tree is to try and simplify an otherwise ungodly set of difficult-to-mathematically-model outcomes that really should be done by robots. Or at least computers. The tree thing just means that there's usually a physical drawing or representation of the potential outcomes.

Related or Semi-related Video

Finance: What is a naked option/position...7 Views

00:00

Finance a la shmoop what is a naked option or naked option position? alright

00:09

warning you're going to be disappointed in this video it's not nearly as hot as [Censored man jumps into lake]

00:13

you probably hope naked options are just options that you sell or buy without

00:18

having enough of the underlying security to cover your if the price changes in

00:24

the wrong direction all right well they're an investment

00:26

that stands on their own but with extreme amounts of risk.....You invest [Man discussing investment in a lake]

00:34

$10,000 in coca-cola stock at 40 bucks a share buying 250 shares the stock goes

00:39

up $2 in a year or 5% not a bad score and you've made a whopping five percent on

00:45

your money or about five hundred bucks you bought the stock not the option and

00:50

remember when you own the stock you can own it forever there's no clock ticking [Clock ticking by]

00:53

in the background like there is with an option okay but let's say you had spent

00:57

that same 10 grand worth of naked coca-cola call options on options with a

01:02

strike price of 42.50 expiring in four months well the stock remains at 42.50

01:08

the whole time doesn't budge well guess what you've lost all of your money [Man with empty jean pockets]

01:13

had the stock under $45 however that 10 grand invested in those call options

01:18

which bought you exposure to some 20,000 shares would have made you something

01:22

like 250 a share that's of in-the-money value on those options times 20,000

01:27

shares or 50 grand yeah way more than your boring experience of just owning

01:33

the stock and making a whopping 500 bucks but you'll also risk losing

01:37

everything and this kind of foot's with whole notion of risk and reward being [Man in between reward and risk]

01:42

married in some unholy alliance where they kind of wrestle and yell at each

01:46

other all the time right so you took a lot of risk in buying

01:49

call options with nothing behind them you bought em naked

01:52

you could have made a fortune but you didn't because he played it safe and

01:55

bought the stock well in reality professional investors rarely just buy

01:59

naked options alone because they are so risky and so volatile but every now and [Ball spinning on roulette wheel]

02:05

then somebody bets the ranch on 22 black it comes up they make 36 times their

02:10

money in a week and everyone asked them for the best way to angle their thumb

02:15

when they're trying to flip a head on a quarter and we actually have a whole

02:18

video on that you should watch it it's kind of depressing...

Up Next

Finance: What is Intrinsic Value (of An Option and of an Asset)?
6 Views

The intrinsic value of an option is the share price of a stock minus its strike price - i.e. the "in the money" amount.

Finance: What are Theta and Theta Decay?
10 Views

Theta refers to either the amount of time left on a contract, or the sorority girl asking if you want to come to her mixer. The answer will always...

Find other enlightening terms in Shmoop Finance Genius Bar(f)