Applications of the Binomial Distribution to Evaluate Call Options

1 What is an Option?

In the most basic sense, an option is a contract conveying the right to buy or sell a designated security at a stipulated price. The contract normally expires at a predetermined date. The most important aspect of an option contract is that the purchaser is under no obligation to buy; it is, indeed, an “option.” This attribute of an option contract distinguishes it from other financial contracts. For instance, whereas the holder of an option may let his or her claim expire unused if he or she so desires, other financial contracts (such as futures and forward contracts) obligate their parties to fulfill certain conditions.

A call option gives its owner the right to buy the underlying security, a put optionthe right to sell. The price at which the stock can be bought (for a call option) or sold (for a...