Real Options

Real Options methods help to structure iterative delivery staged investments and prioritisation based on the financial derivative option valuation techniques. A “real option” is the right, but not an obligation to take a certain action in the future (such as implementing a feature or committing to a milestone release date). Unlike financial derivatives based on which the method is named, real options are not traded or sold. Instead, the thinking behind derivatives trading with options is used to evaluate when to take a certain action, and if to take it at all at that point.

The financial derivative option is a contract that gives the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a specified time frame. The underlying assets could be financial currency, stocks or pretty much anything that can be traded on the financial markets. Options allow buyers to manage risks on the financial markets. For example, a company exposed to EUR/USD currency fluctuation risks might buy a option to purchase 1.000.000 USD at the end of a long project for a specific amount of EUR. If the exchange rate increases for USD in that period, they can exercise an option, effectively freezing the exchange rate they prefer. If the dollar falls against the euro, they can just ignore the option and pocket the profit from the foreign change. The cost of the option is how much they pay for the flexibility to purchase dollars at a later date.

Real Options for software delivery were popularised by Olav Maassen and Chris Matts. According to them, applying real options for product development revolves around three key principles:

Considering that items in a future product roadmap are options (not commitment), helps to defer decisions to the last responsible moment, and also establish when is that specific moment for a particular action. For example, an option to develop a mobile application has the potential value to increase user retention due to more frequent engagement, and the price to execute that option is the cost of developing the mobile application. Avoiding commitment about mobile application development also has value related to both the uncertainty around the exact features of the mobile application and the risk to delay other activities and initiatives in order to develop it. Working out when is the latest responsible moment to commit to this initiative helps to establish the expiry for the option, and then allows product managers to compare it with other options.

Although financial derivative options require fairly complicated mathematics to effectively price and understand, this level of detail is not necessary (or useful) for considering real options for product delivery. It’s more important to establish relative value of a real option compared to other options than to precisely price it. Simple scoring methods such as ICE or RICE can be used for establishing the value of an option relative to others.

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