Analyzing Xp With Options Pricing

There are four particularly important kinds of options that occur in real projects, and I think that XP supports the development of all of them.

Option to abandon
if you find that the overall business value of your project has diminished, you can abandon it. XP provides an explicit abandonment step. Abandonment value is increased by virtue of having developed and used core skills whose value is retained under abandonment. Many processes do not consider explicitly the idea of abandonment (except in terms of "failure" and "disaster").

Option to switch
this is very explicit in XP, the option to switch course that is created by the continuous re-evaluation of what you are doing and where you are going, and by not assuming a priori that you will never change direction.

Option to defer investment
This is the one I really am impressed with, because here XP really goes against the grain of IT conventional wisdom. Conventional wisdom says that you should always build in stuff early, even if it's not clear yet that you'll need it later. XP acknowledges explicitly that sometimes it's better to wait, because the projected value of making that early investment may not materialize. XP explicitly recognizes the value of your option to wait.

Growth option
investment to take advantage of a possible future opportunity. Well, okay, this is a little less clear in the case of XP, but the fact that XP encourages development of core capabilities that can be employed if the market opportunity explodes helps.

Now, here are the main factors that influence the value of any option:

Far and away the biggest influence of all those factors is the third one: the amount of uncertainty. This says that XP exhibits the most value in uncertain environments, where "anything could happen" in the external environment. In certain environments, where the future is stable and well-understood, a traditional plodding development process is fine, because you can predict exactly what you're gonna need and when.

-- JohnFavaro (also thanks to MaroanMaizar)

The finance theorists call the use of options pricing for evaluating projects 'Real Options'. However it is a bit iffy to use analogies with options on traded assets because they have peculiar properties. (Although it is quite a good way of justifying ludicrous valuations of dotcom companies :)

In particular with options on traded assets more uncertainty == more value and expected return on the underlying thing is irrelevant. In options on non-traded things this isn't necessarily the case. This is because with the traded asset you can (in theory) have a strategy to continuously buy and sell it and end up with something that behaves exactly like your option. You can't do this with an option on something which is not traded.

-- ChrisCottee

Actually, "more uncertainty = more value" even if an underlying asset of an option is non-traded. This is an artifact of an option's non-linear payoff. By definition, the payoff function is skewed towards the upside, so when you increase uncertainty, you increase the upside potential, but the downside risk remains limited. So the option value, which is in essence an expected value, also increases. The rational exercise principle -- i.e., exercise only if expected payoff at the time of exercise is positive -- ensures this. Tradeability has little, if any, to do with uncertainty-value relationship.

For valuation purposes, financial option-real option analogy may indeed be iffy. As a reasoning tool, this technical assumption is not that critical, especially when comparing alternatives. Think of option value as an "idealized value" relative to a hypothetical benchmark (an imaginary trading strategy replicates the payoffs of the option), as a ranking metric, not as fair market value. Besides, not all option pricing methods rely on traded-asset assumption. Use your favorite option pricing technique. It is even possible to get significant insight by valuing an option through good old decision tree analysis. Risk-neutral valuation, a popular option pricing technique, is attractive because it requires less information although it relies on tradeability. It's also easy to combine with decision tree analysis. Otherwise one needs to explicitly estimate a probability distribution for the payoff, which is not less problematic than tradeability.

-- HakanErdogmus (June 24, 2002)

Could the option to grow be the same as the XpMayScale?? Or perhaps XP abandons the value of this option in favor of the value of the other three. More the latter, I think

"Option to abandon" doesn't seem quite right: I happen to be reading the ProcessPatternsBook by ScottAmbler this week, and he hammers home that in the "Justify Stage" (one of the first things one does when a project starts), one must determine if the project is feasible, and kill it if it's not. I think that most methodologies do at least lip service to the planned "cancelability" of projects -- at the beginning, during the project approval process.

(In practice, the "Justify" stage is used to perform heavily slanted sales presentations to the GoldOwners. But that's another issue. ;-)

I think a big advantage to IncrementalDelivery is that it gives the users the option to abandon the project at (nearly) any time -- and still preserve the value (development effort) that has been invested thus far. That is, you have the "option to abandon, and declare the project a success."

I think the "Growth option" with XP would be related to maintainability: Because of DoTheSimplestThingThatCouldPossiblyWork and RefactorMercilessly, the system is highly maintainable and can be changed easily. With waterfall development, flexibility in ways that were designed into the system early on is easy, but changing the system in other ways is relatively hard.

-- JeffGrigg

Found this reference:

"Software design as an investment activity: A real options perspective," K.J. Sullivan, P. Chalasani, S. Jha, and V. Sazawal, in Real Options and Business Strategy: Applications to Decision Making, L. Trigeorgis, consulting editor, Risk Books, December 1999, pp. 215

Anyone read the book?

I haven't read the whole book, but I read the chapter by Sullivan et al. The authors discuss how to reason about some software development strategies as real options using decision trees and dynamic programming. Another article on software investments and real options is "Value Based Software Reuse Investment", by JohnFavaro et al. in Annals of Software Engineering, Vol. 5 (1998), pp. 5-52. John and I also wrote a chapter on this for the book XP Perspectives, entitled "Keep Your Options Open: Extreme Programming and the Economics of Flexibility". You can find it at or at -- HakanErdogmus

See more financial arguments for XP at FinancialEffectsOfIterations.
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