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. Option Agreement

    An option agreement is a legal contract between two parties outlining ...
  2. Option Premium

    1. The income received by an investor who sells or "writes" an ...
  3. Option Class

    The set of all the call options or all the put options for a ...
  4. Option

    A financial derivative that represents a contract sold by one ...
  5. Call Option

    An agreement that gives an investor the right (but not the obligation) ...
  6. Stock Option

    A privilege, sold by one party to another, that gives the buyer ...
Related Articles
  1. Investing

    Give Yourself More Options With Real Estate Options (PEI, CME)

    Real estate options have many benefits, including a smaller initial capital requirement.
  2. 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.
  3. Trading

    Getting Started In Forex Options

    Stocks are not the only securities underlying options. Learn how to use FOREX options for profit and hedging.
  4. Trading

    How to Make Money by Trading Index Options

    Index options are less volatile and more liquid than regular options. Understand how to trade index options with this simple introduction.
  5. Trading

    Exploring The World Of Exotic Options

    Exotic options provide investors with new alternatives to manage their portfolio risks and speculate on various market opportunities. The pricing for such instruments is considerably complex, ...
  6. Trading

    The 4 Advantages of Options

    Flexible and cost efficient, options are more popular than ever. Find out why.
RELATED FAQS
  1. What's Required for a Stock to Trade as an Option?

    Learn the four criteria companies must meet before options on their stock can be traded. Read Answer >>
  2. Regular Vs. Exotic Options: What's the Difference?

    Before learning about exotic options, you need a fairly good understanding of regular options. Read Answer >>
  3. Are there any risks involved in trading put options through a traditional broker?

    Explore put option trading and different put option strategies. Learn the difference between traditional, online and direct ... Read Answer >>
Hot Definitions
  1. Cryptocurrency

    A digital or virtual currency that uses cryptography for security. A cryptocurrency is difficult to counterfeit because of ...
  2. Financial Industry Regulatory Authority - FINRA

    A regulatory body created after the merger of the National Association of Securities Dealers and the New York Stock Exchange's ...
  3. Initial Public Offering - IPO

    The first sale of stock by a private company to the public. IPOs are often issued by companies seeking the capital to expand ...
  4. Cost of Goods Sold - COGS

    Cost of goods sold (COGS) is the direct costs attributable to the production of the goods sold in a company.
  5. Profit and Loss Statement (P&L)

    A financial statement that summarizes the revenues, costs and expenses incurred during a specified period of time, usually ...
  6. Monte Carlo Simulation

    Monte Carlo simulations are used to model the probability of different outcomes in a process that cannot easily be predicted ...
Trading Center