What is a real option?
A real option is the opportunity to choose between different possible courses of action in business or investment, each with its own risks and potential rewards. In other words, a real option gives the holder the right, but not the obligation, to take an action. This means that the holder can choose whether or not to exercise the option, depending on what is most advantageous at the time.
The concept is often used in capital budgeting to make decisions about whether or not to invest in new projects. For example, a company might have the option to invest in a new factory or machine. If the market conditions are right, it might choose to do so, but if not, it can simply walk away from the project.
A real option itself, is the right—but not the obligation—to undertake certain business initiatives, such as deferring, abandoning, expanding, staging, or contracting a capital investment project. For example, real options valuation could examine the opportunity to invest in the expansion of a firm’s factory and the alternative option to sell the factory.
Real options are generally distinguished from conventional financial options in that they are not typically traded as securities, and do not usually involve decisions on an underlying asset that is traded as a financial security. A further distinction is that option holders here, i.e. management, can directly influence the value of the option’s underlying project; whereas this is not a consideration as regards the underlying security of a financial option. Moreover, management cannot measure uncertainty in terms of volatility, and must instead rely on their perceptions of uncertainty. Unlike financial options, management also have to create or discover real options, and such creation and discovery process comprises an entrepreneurial or business task. Real options are most valuable when uncertainty is high; management has significant flexibility to change the course of the project in a favorable direction and is willing to exercise the options.