Real options valuation

Methods of real options, "Real Options" Underlie Agile Practices

Jun 08, 16 min read by Chris Matts Whether people realise it or not, "freedom to choose" is the underlying principle behind many of the agile practices. We call this principle Real Options. An understanding of Real Options allows us to develop and refine new agile practices and take agile into directions it hasn't gone before.

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Real Options also help us understand why some people resist some of the practices. To use a familiar phrase, Real Options is about "deferring decisions to the last responsible moment," which is an explicit principle in the Lean Software approach.

By avoiding early commitments, you gain flexibility in the choices you have later. A more formal definition will follow.

Contact What is real options theory?

To illustrate this let's look at some agile practices and point out where commitments are avoided as long as possible. These are just a few examples. Once you become aware of Real Options you will discover a lot more.

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Dynamically control the availability of application features to your users. Start Free Trial. Behaviour Driven Development and Test Driven Development provide many options, especially "the option to change the software, knowing when you have broken it.

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In other words, test driven development removes the need for design commitments, the choice of design can be deferred until after the coding has methods of real options.

More subtly, Test Driven Development allows the developer to know with certainty that they have finished, instead of determining beforehand when the programming is done. Test driven development requires no decision at all, simply stop coding when all the tests are green.

Similarly mock objects allow the developer to defer the decision on how to implement a class until a later time when they have more information on what is required from the class. They also create a nice recursive implementation pattern. XP and Scrum defer the decision about which story to develop until just before the coding starts. This allows the team to incorporate information that arrives at the last moment, such as a new client request.

The Scrum Backlog provides a forum where any idea for functionality can be recorded without requiring an immediate commitment to build it.

At the project Chris is working on, the development is prioritised based on client requests. In effect, sales drive the methods of real options process by stating the relative importance of a client.

Real Option

The team doesn't start working on a feature until the clients have requested it. Now the team waits to see what the clients actually request. By delaying commitment on the features built, the team is able to reduce time-to-market for new features requested. When the client requests a feature the team is free to act, because they are not tied up working on unwanted features. This is only possible with short iterations and a fast turnaround on regression testing.

Pairing provides options in that more than one developer will have an intimate knowledge of any part of the system. This mitigates the "truck number" a.

The truck number is the size of the smallest set of people in a project such that, if all of them get hit by a truck, the project would be in serious trouble [1]. By spreading the knowledge of the system the project is not in danger when anyone on the team wins the lottery.

Real options valuation

So What are Real Options? Real Options is an approach that allows people to make optimal decisions within their current context. This may sound difficult, but in essence it is a different view on how we deal with making decisions.

There are two aspects to Real Options, the mathematics and the psychology. The mathematics of Real Options, which is based on Financial Option Theory, provide us an optimal decision process [2].

The psychology of uncertainty and decision making based on Neuro Linguistic Programming [3][4] and Cognitive Behavioural theory tells us why people do not follow this optimal decision process and make irrational decisions as a result. Financial options are options written and stock and shares. A huge amount of mathematics has been developed to price and risk manage these options. Real Options are real world decisions. Much of the existing literature explains how we can use the Black Scholes formula to price real options.

Making Real Options Really Work

Fisher Black and Myron Scholes along with Robert Merton are Nobel Prize winning economists who invented an equation to value financial options. Unfortunately, most of that literature is wrong when applied to Real Options. We cannot price real options using Black Scholes' famous equation.

A real option is an economically valuable right to make or else abandon some choice that is available to the managers of a company, often concerning business projects or investment opportunities. Real options differ thus from financial options contracts since they involve real i.

Whereas a PhD or Masters in financial mathematics is required to derive Black Scholes or prove the statement we just made, no methods of real options of maths is required to use the results of these maths. The "only" things that the Financial Option maths can tell us about options are: Options have value.

Options expire. Never commit early unless you know why.