What is a 'Real Option'

A real option is a choice made available with business investment opportunities, referred to as “real” because it typically references a tangible asset instead of financial instrument. Real options are choices a company’s management makes to expand, change or curtail projects based on changing economic, technological or market conditions. Factoring in real options impacts the valuation of potential investments, although commonly used valuations, such as net present value (NPV), fail to account for potential benefits provided by real options.

BREAKING DOWN 'Real Option'

Real options do not refer to a derivative financial instrument, but to actual choices or opportunities of which a business may take advantage or may realize. For example, investing in a new manufacturing facility may provide a company with real options of introducing new products, consolidating operations or making other adjustments to changing market conditions. In the course of making the decision to invest in the new facility, the company should consider of the real option value the facility provides. Other examples of real options include possibilities for mergers and acquisitions (M&A) or joint ventures.

The precise value of real options can be difficult to establish or estimate. Real option value may be realized from a company undertaking socially responsible projects, such as building a community center. By doing so, the company may realize a goodwill benefit that makes it easier to obtain necessary permits or approval for other projects. However, it’s difficult to pin an exact financial value on such benefits. In dealing with such real options, a company’s management team factors potential real option value into the decision-making process, even though the value is necessarily somewhat vague and uncertain.

Understanding the Basis of Real Options Reasoning

Real options reasoning is a heuristic – a rule of thumb allowing for flexibility and quick decisions in a complex, ever-changing environment – based on logical financial choices. The real options heuristic is simply the recognition of the value of flexibility and alternatives despite the fact that their value cannot be mathematically quantified with any certainty.

Thus, real options reasoning is based on logical financial options in the sense that those financial options create a certain amount of valuable flexibility. Having financial options affords the freedom to make optimal choices in decisions, such as when and where to make a specific capital expenditure. Various management choices to make investments can give companies real options to take additional actions in the future, based on existing market conditions.

In short, real options are about companies making decisions and choices that grant them the greatest amount of flexibility and potential benefit in regard to possible future decisions or choices.

RELATED TERMS
  1. Exotic Option

    An option that differs from common American or European options ...
  2. Listed Option

    A listed option is a derivative security traded on a registered ...
  3. Call Option

    An agreement that gives an investor the right (but not the obligation) ...
  4. Option Disclosure Document

    The option disclosure document is a publication issued by the ...
  5. Stock Option

    A privilege, sold by one party to another, that gives the buyer ...
  6. Interest Rate Options

    An interest rate option is a financial derivative allowing the ...
Related Articles
  1. Trading

    Stock Options: What's Price Got To Do With It?

    A thorough understanding of risk is essential in options trading. So is knowing the factors that affect option price.
  2. Trading

    A Newbie's Guide to Reading an Options Chain

    Learning to understand the language of options chains will help you become a more effective options trader.
  3. Trading

    Getting acquainted with options trading

    Learn about trading stock options, including some basic options trading terminology.
  4. Trading

    Exploring European Options

    The ability to exercise only on the expiration date is what sets these options apart.
  5. Trading

    Options Basics Tutorial

    Discover the world of options, from primary concepts to how options work and why you might use them.
  6. Investing

    Take Advantage of Employee Stock Options

    If your employer offers stock options, they can contribute to your long-term financial success. Here's how.
RELATED FAQS
  1. How can I find out which stocks also trade as options?

    The trading of options has become increasingly popular among retail investors as they become aware of the many different ... Read Answer >>
  2. How can derivatives be used to earn income?

    Learn how option selling strategies can be used to collect premium amounts as income, and understand how selling covered ... Read Answer >>
  3. Is it possible to trade forex options?

    Yes. Options are available for trading in almost every type of investment that trades in a market. Most investors are familiar ... Read Answer >>
  4. Regular Vs. Exotic Options: What's the Difference?

    Before learning about exotic options, you need a fairly good understanding of regular options. Read Answer >>
Hot Definitions
  1. Internal Rate of Return - IRR

    Internal Rate of Return (IRR) is a metric used in capital budgeting to estimate the profitability of potential investments.
  2. Limit Order

    An order placed with a brokerage to buy or sell a set number of shares at a specified price or better.
  3. Current Ratio

    The current ratio is a liquidity ratio that measures a company's ability to pay short-term and long-term obligations.
  4. Return on Investment (ROI)

    Return on Investment (ROI) is a performance measure used to evaluate the efficiency of an investment or compare the efficiency ...
  5. Interest Coverage Ratio

    The interest coverage ratio is a debt ratio and profitability ratio used to determine how easily a company can pay interest ...
  6. Cash Conversion Cycle - CCC

    Cash conversion cycle (CCC) is a metric that expresses the length of time, in days, that it takes for a company to convert ...
Trading Center