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 Call Option?25 Views
finance a la shmoop. what is a call option? option? option, where are you? okay
yeah yeah. not phone options, call options. and a close but no cigar. a call option [man smokes in a tub of cash]
is the right to call or buy a security. the concept is easy the math is hard.
you think Coca Cola's poised for a breakout as they go into the new low
calorie beverage business. their stock is at 50 bucks a share and you can buy a [man stands on a stage as crowd cheers]
call option for $1. well that call option buys you the right
to then buy coke stock at 55 bucks a share anytime you want in the next
hundred and 20 days. so let's say Coke announces its new sugarless drink flavor
zero it's two weeks later and the stock skyrockets to fifty eight dollars a
share. you've already paid the dollar for the option now you have to exercise it. [man lifts weights]
so you buy the stock and you're all in now for fifty five dollars plus one or
fifty six bucks a share and your total value is now fifty eight bucks. well you
could turn around today and sell the bundle that moment, and you'll have
turned your dollar into two dollars of profit really fast. and obviously had the [equation on screen]
stock not skyrocketed so quickly well you would have lost everything. still you
lucked out and now you're sitting on some serious cash, courtesy of your call [two men in a tub of cash]
options. as for Coke flavor zero turned out to be nothing more than canned water.
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