The binomial lattice is simply a mathematics and logic procedure that tries to predict the trading price of an option at any given time. Option prices become more predictable as they near their exercise date, so a binomial lattice analyzes the possible option prices given a gradually narrowing price range. Each option will have its own possible array of prices, depending on market conditions. You can combine these options into a lattice, although it will no longer be binomial, but rather pentanomial.
1. Obtain access to a computer with a sophisticated options pricing software program. The mathematics for computing options prices is at the theoretical level, using the Black- Scholes pricing model and binomial lattices. While it is straightforward for experienced investment analysts, the sheer number of calculations at the quadrinomial level is impractical to do by hand.
2. Input the necessary variables. At a minimum, you will need to input several variables. This includes the present value of the underlying options, the risk-free rate of return, the trading and other costs to implement the strategy, the time horizon, or time to maturity, and the expected volatility. You will also need to enter the number of iterations you want the computer to perform. The more iterations, the more detailed your lattice. But it also requires more computing power.
3. Press "calculate." The result will be the predicted pricing range of the two underlying call options, priced together, at a specific point in time, given the specific inputs.
Items you will need
- Options pricing software
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