A model used for evaluating options employs a tree-like structure, where each node represents a possible price of the underlying asset at a given time. This iterative approach divides the option’s life into discrete time steps, calculating the option’s value at each step based on the probabilities of price movements. For instance, if a stock’s price is currently $100, the model might project it to be $110 or $90 in the next period. The option’s value is then recursively computed backward from the final time step to the present.
This model offers a straightforward and relatively simple method for option pricing, particularly valuable when dealing with American-style options, which can be exercised before expiration. Its flexibility allows for incorporating dividends and other factors influencing option value. Historically, it served as a foundation for more complex pricing models and remains a useful pedagogical tool for understanding option behavior.
