Numerical Methods for Option Pricing

Abstract

Nowadays, financial markets have become more complex and have given rise to more research opportunities, one of which focuses on research related to the pricing of various financial instruments used in options trading. In this essay, a gradual process of reflection is used to deepen the option pricing theory. Firstly, an effective mathematical method for pricing option contracts is using the binomial tree model, a relatively straightforward way of calculating the value of an option. However, it has only two upward and downward trends and has limitations that are the most different from the actual market conditions. That is why the study will have to continue in-depth to get as close as possible to the real situation in the market. The next step is to make the model more in line with market reality by adding a possible rate of change, resulting in the Trinomial Tree Model. The model incorporates the possibility of future price increases, decreases, or stabilization (the third change). The Trinomial Tree Model follows the no-arbitrage principle and removes the assumption of a risk-free market opportunity. This paper derives a method for constraining market prices under risk-neutral conditions. This is crucial for investors seeking profitable outcomes in options trading. The main objective of this research-based paper is to develop a complete theory of option pricing in a one-step trinomial tree model.