Decisions, Decisions or Why Baskets of Options Dominate

“Crazy. They believe that an option on a basket is better than a basket of options.” My interjection abruptly halted the executive conversation about goal setting I was participating in. Only for a moment, though. After an awkward pause, the conversation resumed as if I hadn’t spoken.

Reflecting, I think I’m onto something important. My cohort of thinkers learned a lesson through pain and reflection, a lesson that seems to be slipping from our collective grasp. It’s time to bring it back.

I invite you to inform your intuition and challenge your beliefs. It’s going to take some work, but it’s worth it.

Options

Let’s say you have a share of Gusto stock worth $1 (<- gratuitous employer callout, yes we’re hiring). What happens to the value of your holding if the price changes tomorrow to $2? Stays at $1? Goes, heaven forfend, to $0? Write out your answers before proceeding. I told you this would take work.

With a share of stock, you make money when the price goes up and lose when the price goes down

Okay, so you just read ahead instead of writing out your answers. How are you going to learn if you don’t do the work? We’re talking about deeply held beliefs here. I’ll give you another chance and then I’ll give up on the finger wag.

What if, instead of a share of Gusto stock, you have a promise that you can buy a share of Gusto stock tomorrow for $1? Seems like this would be worse. Having a thing is better than having a promise that you can buy a thing. A bird in the hand and all that…

However, the cool thing about the promise (technically a call option or henceforth just an option) is that you don’t have to call in the promise. Work out the three scenarios for yourself. Write down your work.

My answers:

An option transfers downside risk

If the price of a share goes up, you call in the promise (technically called “exercising”) and buy the share for $1 then immediately sell it for $2, gaining a dollar. It’s no different than owning the share, financially.

If the price doesn’t change, you can exercise the option, buy the share for $1, and immediately sell it for $1 for a net sum of nothing. Or you can save yourself the hassle and just ignore the option (let it lapse).

So far holding the promise is no different than holding the share. The magic is what happens when the share price goes down. Now, instead of losing a dollar you just let the option lapse and don’t lose anything. (Actually the loss is transferred to whoever sold you the option, but that’s a story for another day.)

Holding the option dominates holding the share. It’s never worse and it’s sometimes better.

Play with these ideas. Forming a strong intuition about the relationship of shares to options is the basis for what comes next.

Baskets

  • Both go up
  • One goes up, one stays the same
  • One goes up, one goes down (I’ll just let you guess which is which but I have my bias)
  • One stays the same, the other goes down
  • Both go down

Write down your answers for these 5 scenarios, then compare to my answers.

A basket sums the outcomes of the elements

We get the sum of the price changes.

Option on a Basket

Holding such an option, if both prices go up we exercise. We buy 2 shares of stock for $2 and immediately sell them for $2 each for a total profit of $2. Write out the value of the 5 scenarios.

Here’s my answer:

Option on a basket eliminates downside risk

Notice that if the sum of the two prices is less than or equal to $0, then we just let the option lapse and don’t lose any money. This feature of the “option on a basket”, that the two investments are linked, is a bit icky. We’d like to be able to take advantage of price increases regardless of where they occur.

Basket of Options

Here are my answers:

Basket of options preserves value when one items goes up and one goes down

The basket of options lets us profit whenever one price goes up, regardless of what happens to the other price. The troublesome linkage is gone.

Holding a basket of shares is dominated by holding an option on a basket of shares. The option on a basket always makes as much money and sometimes more. However, the basket of options dominates the option on a basket. It’s always worth at least as much and sometimes more. Basket of options >> option on a basket >> basket.

Time to apply your growing intuition.

Examples: Roadmaps, Launches, and KRs

Roadmaps

The typical roadmap is a list of features to be implemented. Approving a roadmap is exercising an option on a basket of features.

Roadmaps couple the risk of elements

Contrast this with Extreme Programming-style weekly cycles. Monday you choose what to do, do it all week, and report on the observed outcomes on Friday. This is a basket of options.

Weekly planning creates a stream of options

Apply what you just learned. In what circumstances is a basket of options more valuable than an option on a basket? Exactly when the value of one item drops. This happens all the time in product development. A feature you expect to be great fizzles while some obscure little tweak turns to gold.

A basket of options dominates an option on a basket. Weekly planning dominates a roadmap. (In theory, yes, I get it, but…)

Launches

For a big launch to go well, both product development and the launch itself have to go well. (This linkage may sound familiar. I intend for it to.)

Big launches couple product and launch risk

When you encounter long lead times, you’re hearing option-on-a-basket thinking. “We need to know what features will be in the release in 8 months so Marketing has time to prepare.” What if product development doesn’t go according to plan? The value of the option on a basket falls to zero. What if the launch doesn’t come off? The value of the option on a basket falls to zero.

How can we make this a basket of options? We must change what is communicated as part of the “launch”. We no longer say, “Hey, this brand new thing, it’s really great.” Instead marketing is a celebration of accomplishments, an acceleration of successes already deployed.

Celebration “launches” decouple risk

“Gusto issues 1% of all U.S. paychecks.” Marketing in this style eliminates the compounding risk of big product development and big launch. You still need enough early marketing to get to those milestones, but that requires smaller risks on shorter timelines.

KRs

The proposal I reacted to was to base performance review on a portfolio of key results. Achieving 70% of each goal was acceptable. 100% was great. All of the goals had to be satisfied, though, to get a positive review.

The proposal looks reasonable. You wouldn’t set goals unless you thought they were important. Not doing something important is bad. You need to be able to count on people and teams.

Predicted KRs couple the risk of failure

But… You can’t count on people and teams, and not because people and teams are inherently unreliable. The problems they are solving are unreliable and subject to change. Both the ends to be achieved and the means to achieve them change.

An option on a basket of goals creates a perverse incentive for the executors of the work to sandbag their goals. If bad things happen if I achieve less than 70%, then I’m going to damn sure discount the 70% “of what” until I’m sure I can make it. Which leads to the planners inflating the “of what”. Which leads to more sandbagging.

Maybe what’s wrong here isn’t the execution of the planning process. Maybe the beliefs underlying the planning process are flawed. What does planning look like when we believe that a basket of options >> an option on a basket?

P50 goals, which are 50% likely to be achieved, are options. As long as roughly half of the goals are achieved, then you’re doing fine.

P50 goals create incentives for discovery and learning

P50 goals address sandbagging. If you achieve all of your goals, you receive a demerit on your review. Achieving none of your goals is also bad. The best possible result is a new goal, more valuable than any of the predicted goals, that was discovered and satisfied during the review cycle.

(I have objections to performance review cycles in general, but again, story for another day.)

Decision Fatigue Misapplied?

In spite of dominating options on baskets, baskets of options have one cost that is undeniably higher — decisions. Choosing whether or not to exercise a financial option is simple — is the current price higher than the option’s strike price? Choosing whether or not to exercise a real option, however, requires judgement. At the moment you exercise the option to, for example, develop a feature you still don’t know its precise cost or value.

The zeitgeist economizes on decisions. Decision fatigue is a subject of serious psychological and economic study. Steve Jobs is mythologized for saving his decision mojo for more important topics than his daily wardrobe. (I happen to think this results in boring style, but if you’ve seen me you probably already knew that.) Perhaps this trend has gone too far.

The shift to options on baskets is consistent with people trying to minimize the number of decisions they make. Perhaps “decisions are a scarce resource and must be eliminated” is the belief beneath the belief that options on baskets are okay. I don’t know. As I said, this is rank speculation.

Conclusion

Kent is a long-time programmer who also sings, plays guitar, plays poker, and makes cheese. He works at Gusto, the small business people platform.