Real Options

I recently attended XP day where I participated in an open space on Real Options.

Real Options is about “deferring decisions to the last responsible moment”. By avoiding early commitments, you gain the flexibility in the choices you have later. Real Options give you more time to gather more information and explore more options until you have to make a decision. Financial options are just like these, except you are buying the right to purchase or sell an asset instead of the ability to make a decision.

Why do we use Real Options and what are they useful for?

  • To deal with uncertainty – This allows you to postpone really important decisions until the last possible moment.
  • To deal with risk – If you take time to observe and “see what happens next”, this allows you to gather more information and make better informed decisions.

A Real Option has:

  1. A value.
  2. An expiry condition that will tell you when you have to make a decision.
  3. A buying cost and an exercising cost. The buying cost is the cost that is payable now to implement a decision in the future at a fixed cost. The exercising cost is the fixed cost.

To make it clear there are two types of options:

  • Real Option – where the value is more than the costs put together.
  • Stupid Option – where the costs are more than the value itself.

Of course value depends on context so we have to re-evaluate our portfolio of options depending on the context.

The Real Options decision process

  • For a given decision, identify the real options available. This is gathering all the information of all the opportunities that you might have.
  • Identify the last responsible point at which a decision can be made i.e. the conditions to be met to make a commitment. Decision time = deadline – option implementation time.
  • The first decision is made before the first option expires. Until that expiry date, find out when you need in order to exercise those options. During this time actively seek information and clarify the options available as well as their value. Look for new options as well.
  • Identify option(s) for each condition case and know ahead of time which option to exercise given a particular condition.
  • Attempt to push back the decision time because the longer the wait the more information you have and hopefully the more options you’ll acquire.
  • Understand that cost optimisation is not the same as revenue optimisation or risk reduction. Sometimes it is worth investing in more than one option even though this may cost slightly more.
  • Then you wait and wait and wait until the moment when you have to make the decision. Then you can finally make the decision with confidence because you reviewed all your options upfront.

Real options are common sense, but common sense is not common practice. Instinct tells us that we want to make decisions as quickly as possible especially when we are under pressure. The same instinct tells us that it is better to make the wrong decision than to make no decision at all. This is because we are afraid of uncertainty – we do not want to look indecisive or stupid! When we are under pressure, real options can help us make logical decisions and to get value from risk and uncertainty.

Here is an example of Real Options applied to Christmas shopping for a book.

Jack wants to buy a book for his grandmother for Christmas. He identified two ways of shopping:

  • Online
  • Offline

For online shopping Jack identified two delivery methods:

  • Free UK delivery i.e. the super saver option. This takes 7 days.
  • Overnight delivery i.e. the JIT (Just-In-Time)option

Here are the real options Jack identified:

  1. Online shopping with super saver delivery. He identified the deadline to be 24th December and the implementation time is length of super saver delivery. Therefore the decision point is 18th December.
  2. Online shopping with over night delivery. For this option the decision point is later i.e. the 24th December. However, the exercising cost is slightly higher i.e. He would pay more to be able to decide later.
  3. Offline shopping with delivery by Royal Mail. With this option the implementation time is much longer because Jack would have to shop for the book and then send it by Royal Mail. The decision point is sooner. In fact, when he worked out the decision point, he identified that that option had expired.
  4. Offline shopping with Jack delivering the book personally. This reduces the implementation time and adds value as Jack’s grand mother would be glad to see him when he delivers the book. It would take a day to deliver which is still faster than delivery by royal mail.

Jack identifies that time is not the only expiry condition. He is wise enough to also take into account the risk of availability. So he identifies the following ways of extending his off line options:

  1. He would look around shops within a two mile radius and then 10 miles just so that he knows what retailers are available and how he can get a hold of this present.
  2. He would look for alternative gift ideas. This would increase the number of real options he has.

Another online option Jack thought of is to buy a gift voucher. He could buy this online on the 23rd December and then take it over to his grandmother on the 24th. This would take the decision point to a day before the deadline date and the decision of selecting which book would be moved to after Christmas. In this case the decision making process would be deferred to his grandmother so that she can decide which book she wants to buy.

To summarise, a real option has a value, it has an expiry condition, a buying cost, an exercise cost. Use the optimal decision process. Don’t decide now, decide when necessary. Keep your options open, gather information and take the decision when you need to, with confidence.