Trinomial Option Pricing Model

See: Binomial Option Pricing Model.

The act of pricing options is complicated. There are a lot of moving parts.

As a refresher, an option provides the right, but not the obligation, to buy or sell a particular underlying asset (a stock, commodity, currency, etc.) at a pre-set price at some point in the future. In pricing those options, all aspects of that structure come into play. The current price of the underlying asset matters. The amount of time until expiration matters. And all the various factors are in constant flux.

Due to these complications, there are many competing models for pricing options. The most popular is known as the Black Scholes model. Another is known as the binomial option model.

The trinomial model is an expansion of that second one. Developed by a guy named Phelim Boyle, it involves a simplified method of getting to the same answer provided by the binomial method.

The math itself is rather complicated, but the concept behind the process is based on the idea that the future price of the underlying asset has three possible relationships to the current value: it can be higher, it can be lower, and it can be the same. From there, a whole system of wonky math gets you to the option price.