When it comes to investing, we all want real options, right? Depending on how sophisticated your investing strategy is, “real options” may mean something more than you realize.
Real options are actually quite different from traditional options contracts with which you might be most familiar. That’s because real options have more to do with actual, physical assets, rather than stocks or other securities.
Just what are real options, and how do they work? Read on to find out.
Defining Real Options
Real options are options in the purest sense — they give business managers the ability to make a choice regarding a business decision. Typically, these business decisions involve projects or investments that include tangible assets.
Real options give the option holder the right, but not necessarily the obligation, to make the decision. That’s similar to a financial option — a derivative that you’re likely more familiar with, which includes specific types of options contracts like a call option or a put option — in that they both give the option holder a right, but not always the obligation, to make a move.
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A big distinguishing factor between real options and their financial counterparts, though, is that the underlying assets in real options are often tied to some sort of physical, tangible property or asset, like land or equipment, rather than a stock or security. Businesses do not trade options the way that investors do.
Understanding How Real Options Work
The concept of real options is a bit more philosophical than their derivative cousins. Think of it this way: Some of the options facing managers could include the option to expand their business, contract it, or abandon it altogether.
These are choices, not financial instruments. You don’t go to your brokerage account to trade real options. So, in that sense, real options are strategic choices, which require that managers (or whomever the decision makers may be) do their homework. That homework could include doing some serious cost-benefit analysis, forecasting future cash flows, weighing opportunity costs, etc.
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Real Option Example
Say you own a chain of tire stores in Fargo that specializes in selling winter tires. You’re thinking about expanding the business, and the first city on your list of potential expansion targets is Miami.
In this scenario, you’re actively thinking about the option to expand your business. While we generally think of expansion as a good thing, there are a lot of factors to consider in whether or not the decision to expand to Miami is, in fact, a good one.
There’s the key question of whether or not anyone would buy winter tires in Miami, for instance. And how much existing competition there is in the city in the form of other tire shops. Then, you need to think about the opportunity costs of expanding to other markets, or not expanding at all.
With that in mind, it may be best to put expansion on hold — or, to exercise the option to wait. Since we can think of real options as a valuation technique, what you’re really doing is trying to determine the value of the option to expand versus the option to wait, to try and determine the most fruitful path for the business.
Real Option Valuations
As different as real options are from financial options, there are some similarities. That holds true when it comes to valuations, particularly. In fact, analysts can use the valuation tools associated with financial options in addition to traditional discounted cash flow methods.
In other words, we can employ techniques used to value financial instruments, and apply them to non-financial decision-making scenarios. With that, we can think of some real options as “calls,” and others as “puts.”
For instance, executing an option to expand could be thought of as a call, whereas opting to abandon could be a put. Basically, a decision is being treated the same as exercising an option.
But business projects and decisions are complex — massively so, sometimes. So, decision makers are often oversimplifying the variables, making assumptions, and doing their best to run accurate if/then scenarios and make projections. Because of that, valuing real options can be a pretty complicated task, though there are ways to simplify things.
This is a deep topic, and one that likely requires more research if you’re interested. Briefly, however, some popular methods for valuing real options include creating decision trees (a flow chart), using the binomial model, a Monte Carlo simulation, the Black-Scholes model, or net present value.
5 Types of Real Options
There are numerous types of real options. But here are some of the most common:
1. Option to Expand
This one is pretty simple, and has come up a couple of times already. The option to expand is the option to expand a business’ operations. That may include making an additional investment of some kind or starting a new project that will further the overall business’ footprint or market share.
Going back to our earlier example concerning the Fargo-based tire shop chain, executing the option to expand would culminate in the opening of new stores in the Miami area.
2. Option to Abandon
The option to abandon is, well, the option to stop operations. That may mean ceasing operations on a specific project, or mothballing a location or piece of equipment. In effect, this is a decision to scale things down, and try to recover value by salvaging or selling off assets.
An example: Our tire shop chain opens a single new store in Miami, but business isn’t going well. As it turns out, snow tires don’t sell like empanadas along South Beach. As a result, the business decides to shut down the Miami store — exercising the option to abandon the Miami project.
3. Option to Wait
The option to wait is exactly what it sounds like. That may mean that a manager opts to sit on a project and take it on at a later time.
As for why a manager might do so? It may be more profitable or advantageous to take on the project at another time, for instance. Or, if the company is currently expanding resources on other projects and wants to wrap those up before jumping into another, it may be strategically advantageous to do so.
4. Option to Contract
The option to contract involves the option to shut down a project or business at some point, for any number of reasons. While similar to the option to abandon, the option to contract (as opposed to the option to expand) can also involve a simple scaling-down of a project to reduce output.
5. Option to Switch
The option to switch concerns the ability and flexibility to resume or shut down an operation at a given point in time, depending on business conditions. Essentially, this is a hybrid between the option to expand and the option to contract.
For example, the Fargo tire shop may execute the option to switch by giving its staff the summer off, when snow tires are in very low demand, effectively shutting down for a few weeks or months.
The Takeaway
Real options have similarities to financial options, but their underlying assets are real assets rather than financial securities. Real options are choices made by businesses around growing or expanding their business or specific projects.
With some more knowledge about options under your belt, you might be ready to find an options trading platform that’s right for you. SoFi’s options platform has intuitive and approachable design and ample educational resources. Investors can trade options either on the web platform or through the mobile app.
Photo credit: iStock/fizkes
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