Lean Startup and the Principle of Optionality

In an alternate universe, investment banks could have been the pioneers of lean startup. Even in our reality, it ought to be one of the strongest evangelists, by right. The benefits of lean thinking should be so apparent. It’s interesting that it isn’t so.

Principle of Optionality

An option is a type of derivative security. Essentially, options are contracts that grant the right, but not the obligation to buy or sell an underlying asset at a set price on or before a certain date. The right to buy is called a call option and the right to sell is a put option. For example, I own a bakery and I believe that the price of sugar will increase sharply in the next 6 months. I predict it will go up from $3 to $5 a dozen. I know for a fact that I will continually need eggs for my bakery. I then decide to buy a call option to buy eggs 6 months from now, locking in the current price of $3 a dozen. I pay $0.50 for this option. In other words, I bought a call option, taking a long position on the price of eggs, so that no matter how high the price of eggs spikes up, I can still buy the quantity I need at the price that is reasonable to my business.

But what happens if the price of eggs does not go up as I predicted? Even worse, what if the price actually falls? Price of eggs has now gone down to $2.50 a dozen. What should I do with my option? The obvious answer is nothing. I can cry over it for maybe 5 minutes, but any reasonable person would know to NOT use the option and actually buy the eggs at the pre-defined $3 a dozen. And is that allowed as per the contract? Most certainly. Because by definition, options contract allows the buyer the right, but the obligation to buy, which is precisely why it is called an “option.”

Lean Startup

Lean startup is an approach to creatively solve problems by the diligence to continuously experiment, test, track, and improve. It is characterized by the ability to change quickly and stresses the need for experimentation and validation. Moreover, failures are tolerated, and at times (worryingly) celebrated. Fail fast is a philosophy that values extensive testing and incremental development to determine whether an idea is feasible. An important aspect of the philosophy is to cut losses when testing reveals that the idea isn’t good, and quickly try something else. This concept is known as pivoting.

So, Why Hasn’t It Caught Up?

Principle of optionality… pivoting… see the connection?

In the investment world, the concept of options is so ubiquitous that there is an option version of pretty much everything. You’re into foreign exchange? There’s FX options. How about stock trading? There are also stock options, even on indices. How about commodities? Wheat, palm, gold, crude oil… and yes even eggs, there are options available. On solid rule in any variation of option is that whenever the price moves against your prediction, never exercise the option. Be more than willing to cut your minimal losses to prevent further losses.

In the same way, if you have an initiative and you put in a small amount of funding to experiment and validate your idea, would you continue to build your product even if experiment results prove that your idea is a bust? Traders in investments are liberally given funds to place call and put options based on their trading strategies, in order to make money for the firm. These traders would never consider exercising their options if they are deemed out-of-the-money. Nor would they be pressured to by their upper management to do so out of sheer optimism or in order to save face. But why is it not the case with product innovation for investment banks? (or for any bank or financial institution, for the matter).

“Due to a cognitive bias known as the planning fallacy, executives tend to “make decisions based on delusional optimism rather than on a rational weighing of gains, losses, and probabilities. They overestimate benefits and underestimate costs. They spin scenarios of success while overlooking the potential for mistakes and miscalculations. As a result, they pursue initiatives that are unlikely to come in on budget or on time or to deliver the expected returns — or even to be completed.” — Lean Enterprise

The principle of optionality should be our best argument to try to convince executives that it should be ok to make calculated risks, to experiment, and to cut losses if necessary. That without the courage to invest, there would be no possibility of winning. After all, they should know options, their own product, by heart.

“…the principles of constraining time and resources, thus limiting downside, and building a minimum viable product to test your value hypothesis as soon as possible with real customers should be applied at the start of every endeavour.” — Lean Enterprise

If we apply the same genius that is allotted to thinking of different and creative ways to trade (and make money), and instead apply the same zeal to experimentation and innovation, the world would be much more efficient and productive.