Understanding Real Options

WRITTEN BY Mike Cottmeyer

I had the distinct pleasure of spending time with Chris Matts and Olav Maassen last week at the Seattle APLN Leadership Summit. It was a good time all around.

We explored the impolite topics of religion and politics and even shared an idea or two about Agile Leadership. Talking with Chris and Olav was the first time I had anyone sit down and explain to me the concept of Real Options. I was fortunate that I got to hear it straight from the guys that are driving some of the thought leadership in this area.

There is no better way to solidify a concept in your brain than to write about it and teach it others. I am no expert on Real Options but would like to see if I can share with you what I learned. Hopefully we’ll generate some conversation along the way.

The concept of Real Options is very straightforward. It is so straightforward that you can summarize it on the back of a business card:

Options have value
Options expire

Never commit early unless you know why

Like most things that appear simple, I think there is a little more to the story, a little more that needs to be explained.

Options Have Value

An option is a choice. It is a decision to select one strategy over another strategy. To buy one product over another product. To build one feature over another feature. To decide on one course of action over another course of action.

Every choice we make has the possibility to yield a particular return on our investment. Our goal is to maximize the value that we derive from our decision making.

Our options, the decisions we make, have value. The interesting thing here is that it is not just the options we know about that have value, the options we don’t know about have value too. We are generally pretty good at determining the value of the known options, but what about the value of the unknown options? That’s just it… we can’t know the value of an option that isn’t there yet.

We need time to learn about what we don’t know. We need time to understand the value of the unknown.

Options Expire

Options have value, but that value does not live forever, it expires. We cannot wait indefinitely to make a decision and we can’t wait until we know everything. At some point in time, the window of opportunity for a particular option will close, and the value of that choice will no longer be available to us.

Our goal is to keep our options open until just the point they are ready to expire. We use that time to gather more information and to learn about new options that might present themselves.

Waiting to the last responsible moment, just before the option is ready to expire, allows us to make decisions when we have the most possible information available to us. Decisions cannot be held indefinitely… but they can be deferred.

Never commit early unless you know why

Most people want to make good decisions. Unfortunately, most people would rather make a wrong decision than to live with uncertainty.

This was probably the most clarifying concept I learned during my time with Chris and Olav. We would rather be wrong than to defer a decision. Our need for certainty drives us to make decisions before we have to. Sometimes it drives us to make bad decisions.

Waiting helps us make better decisions. Knowing how long we can wait helps us be more disciplined about waiting. Using Real Options theory can help us determine how long we can wait.

If you need to make an early decision, the key is to understand why. Don’t make a decision early for the sole purpose of making the decision. Wait and gather more information. If there is a good reason to make the decision early, and you are comfortable with the outcome, make the decision.

Sometimes there are good reasons for making an early decision. If the value of the option is low or of little risk, you might consider making an early decision. In that case you are making the decision to focus your energy on higher value options. Alternatively, if a situation is high risk and making an early decision would yield an acceptable outcome, that might be a good time to make a decision early. Making the decision would mitigate risk.

Understand why you are making the decision and be aware the limits that decision will place on any current or future options.

So… that is my take on Real Options. If any of you are experts on this topic, please weigh in. I found the concept intriguing and wanted to share with you my understanding.

Thanks!

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