Money matters

An important insight is that if you own a real option, variance helps you: If the price had been $28.09/MWh constant, you would have earned $10.8 million and you would never have shut down or reopened the plant. But because the price was highly variable around $28.09/MWh, you would have earned $28.6 million. It is your ability to “operate only when desired” that has value. Intuitively, “the bigger the upside,” the better for you. “The lower the downside” makes no difference: you are not operating anyway. Variability is on your side!
This does not contradict our intuition from the investments section. There, we posited that you disliked risk (at least systematic risk), and would only take it on if you receive extra expected rate of return. You may still intrinsically dislike risk, and require a higher hurdle (discount) rate for investments with much embedded real option values—such cash flows are typically very risky. But, in the presence of a real option, the risk also increases your expected cash flows—and often so tremendously that you end up much better off with risk than without risk. The present value, taking the higher discount rate into account, can be much greater.
Real options generally arise from your flexibility (here, whether to operate or not to operate). Different technologies have different real options and to different extents. For example, nuclear power plants have higher upfront fixed costs, but lower marginal costs. A nuclear power plant may cost over $1 billion to construct, but it may be capable of producing electricity at costs as low as $5/MWh. Therefore, nuclear energy plants typically run continuously, regardless of electricity price. They have fewer embedded real options. This has another consequence: If you ignore real options, you will mistakenly end up with too many high fixed-cost, low variable-cost technologies. You will believe nuclear power plants are much better than turbine gas plants, even if they are not.
Indeed, many economic resources are nothing but real options. Much R&D, e.g., into a new cancer drug, will never pay off in and of itself. But, if the drug development were to succeed, the pharmaceutical company would create factories and earn billions of dollars. An investment of R&D can thus be considered the purchase of a real option. Similarly, undeveloped land has zero inflows today, and still requires the payment of real estate taxes. Its only value is the real option to build on it if demand for land use were to increase in the future. And, your degree and next job may have more value, because you can walk away from them if other, better opportunities were to appear.

We should already be aware of the problems of back-testing. While there are no other alternatives for validating a proposed trading strategy, it is necessary to look at the problems more carefully to see a solution. No market is more evident than crude oil during the Gulf War, discussed in the previous series of posts. From August 1, 1990, through the end of the War in February 1991, oil prices were driven by news. But not all news is a surprise. In the agricultural markets, a crop freeze in orange juice or coffee is often anticipated by a change in weather. Before a freeze can occur, the temperature must drop. And that low temperature must he sustained to cause damage. This weather change causes processors to protect themselves by buying forward contracts or futures. In turn, prices move up.
Because Iraq had been moving troops near the Kuwait border, their intentions were not a surprise; however, diplomacy failed. The threat of an oil supply disruption caused oil prices to slowly rise. Many systematic traders and commercials would have been long on August 7, 1990, when Iraq invaded Kuwait.