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.
Related or Semi-related Video
Finance: What is a Derivative?23 Views
finance a la shmoop what is a derivative? well it's derived it's a something taken
from something else like a derivative of hot weather is thirst a derivative of [Girl takes sip of glass of water on a beach]
hunger is well you know crankiness that's diva thing you get there...
derivative of a 1/32 quarterback rating in the NFL is like serious wealth yeah
yeah discount double shmoop yeah look for it be on there with aaron
and a derivative of a stock or bond or other security is a something which
derives its value based on the performance of that underlying security
there are basically two flavors of derivative put options ie the right to [Ice cream flavors appear]
sell a security at a given price over a given time period and a call option, ie
right to buy a security at a given price over a given time period
well the price of that option is derived from the price of the security and a few
other factors like strike prices and duration and all that stuff
colonel electric the downgraded new version of General Electric is trading [Colonel Electric appears in a suit]
for 25 bucks a share a derivative of its share price is sold in the form of a
call option with a $30 strike price expiring about 90 days from now on the
third Friday of the end of that month well investors pay a price albeit
probably a small one for the right to then pay 30 bucks a share for colonel [Call option appears for colonel electric]
electric at any time in the next 90 ish days until that option expires making the bet
that the stock will go well above 30 bucks a share in that time period that
call option is thus a derivative of the colonel electric primary stock price got
it if you really want to get personal well here's the ultimate form of
derivative [Baby laying down]
Up Next
What is a put option? A put option is a type of contract that lets the investor sell shares of a stock at a certain price and within a window of ti...
What is a call option? A call option is a type of contract that lets the investor buy shares of a stock at a certain price and within a window of t...