Real Options

After hearing about Real Options at XP day, a little example I thought through of how I unknowingly used the technique recently. From Portia,

Real Options is a decision-making process for managing uncertainty and risk. It’s a simple and powerful approach that helps us make better informed decisions, as individuals and in groups, by understanding and responding to the psychological effects uncertainty has on our behaviour.

Travelling to my parents at Christmas I’d decided the dates but needed to choose the method of travel.

  1. Book train ticket now with reservation.
  2. Defer booking train ticket until nearer the time, possibly no reservation
  3. Hire a car for the trip
  4. Book plane ticket
  5. Book coach ticket

These options present themselves as soon as i’ve decided my time off work but until I know the relative costs and availabaility of them I cannot make a decision. So I look online, find the costs, and I can add the relevant information.

  1. Book train ticket now with reservation – no reservations possible. Buying cost: £60, Exercise cost: £0, Expiry date: imminent
  2. Defer booking train ticket until nearer the time, possibly no reservation. Buying cost: £60, Exercise cost: £0, Expiry date: day before travel
  3. Hire a car for the trip. Buying cost: £150, Exercise cost: £80 (petrol), Expiry date: day before travel
  4. Book plane ticket. Buying cost: £150, Exercise cost: £0, Expiry date: imminent.
  5. Book coach ticket. Buying cost: £30, Exercise cost: £0, Expiry date: 3 weeks before travel

This information lets me rule out Option 1. Why book ticket now for the same cost and availability as Option 2? Option 4 has an imminent expiry date and with it’s increased cost it’s also ruled out. I also have a dislike of coach travel so I ruled Option 5 out despite it’s attractive price.

A week later I checked out the costs and availability of the remaining options. I also introduced travel time to the equation.

  1. Book train ticket now with reservation – no reservations possible. Buying cost: £60, Exercise cost: £0, Expiry date: imminent
  2. Defer booking train ticket until nearer the time, possibly no reservation. Travel time: 2 hours. Buying cost: £60, Exercise cost: £0, Expiry date: day before travel
  3. Hire a car for the trip. Travel time: 4 hours. Buying cost: £150, Exercise cost: £80 (petrol), Expiry date: day before travel
  4. Book plane ticket. Buying cost: £150, Exercise cost £0, Expiry date: imminent.
  5. Book coach ticket. Buying cost: £30, Exercise cost: £0, Expiry date: 3 weeks before travel

As these two options have the same expiry date I waited a little longer. A week later I checked prices and availability again.

  1. Book train ticket now with reservation – no reservations possible. Buying cost: £60, Exercise cost: £0, Expiry date: imminent
  2. Defer booking train ticket until nearer the time, possibly no reservation. Travel time: 2 hours. Some routes are beginning to have no availability. Buying cost: £60, Exercise cost: £0, Expiry date: day before travel
  3. Hire a car for the trip. Travel time: 4 hours. Buying cost: £220, Exercise cost: £70 (petrol got cheaper!), Expiry date: day before travel
  4. Book plane ticket. Buying cost: £150, Exercise cost £0, Expiry date: imminent.
  5. Book coach ticket. Buying cost: £30, Exercise cost: £0, Expiry date: 3 weeks before travel

Given this latest set of information made it easy for me to decide on Option 2 and I bought my ticket. Most of this happened automatically for me, and it probably does for you to. For example,

  • When buying clothes, you see an item you want but it’s the last on the rail. Maybe you hide it, or ask the assistant to reserve it for you. This pushes back the expiration date of the option allowing you to check other shops before making your choice. (Thanks to Portia for this example)
  • Deciding about eating that pizza at 1pm. Defrosting a frozen pizza will take 3 hours, so its buying cost is £3, exercise cost is £0, and the option has an expiration time of 10am. Ordering a take away will have a buying cost of £10, exercise cost of £0 and an expiration time of 12.30pm. The night before you know that waking up at 9am gives you both options, but waking up late reduces your options.

Interesting stuff.

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4 thoughts on “Real Options

  1. Al

    Love the story. Real Options are about the small things that make life easier rather than the BIG strategic decisions ( They help with those but they only occur every once in a while ).

    I have a similar approach to the Agile 200X conference. I book a room as soon as the hotel is announced as I can cancel for free up to a day or so in advance. I also buy a plane ticket. The reason is that currently the tickets are only £350 but I know from experience that the prices go up and up very quickly ( easily more than £350 more ). The real cost is the lost wages which is a lot more than the £350 flight cost.

    So I buy the option to go (with hotel rate as exercise cost) for £350.

    Have you thought about joining the real_option_discussion yahoo group?

    Chris

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