Details

Under the binomial method [1], the underlying asset price is modeled as a recombining tree, where at each node the price can go up and down. These values are found by multiplying the value at the current node by the appropriate factor or

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with corresponding probabilities

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To make sure that these probabilities are in the interval , the condition should be satisfied.

Once the binomial lattice of all possible asset prices up to maturity has been calculated, the option value is found at each node by working backward from the final nodes to present.

The difference between the binomial and trinomial model [2] is that the option value at each non-final node is determined based on the two later nodes and their corresponding probabilities (as opposed to three). The binomial model is considered to produce less-accurate results than the trinomial model when fewer time steps are modelled.

Reference

[1] J. Cox, S. Ross, and M. Rubinstein, "Option Pricing: A Simplified Approach," Journal of Financial Economics, 7(3), 1979 pp. 229–263.

[2] P. Boyle, "Option Valuation Using a Three Jump Process," International Options Journal, 3, 1986 pp. 7–12.