Real options are options which arise in real investments, that is investments in real assets, in which there is flexibility to take decisions in the light of subsequent information. The flexibility may be the choice of either increasing the level of output of a production process now or waiting until later when more is known about the likely level of demand. Real option theory is primarily concerned with valuing this flexibility and determining the optimal timing of such investment decisions.

The freedom to wait before taking the complete investment decision makes it more difficult to value projects. In the absence of flexibility, the expected values of future cash flows from the investment are estimated and then valued in today's pounds or dollars, allowing a discount for the risk or uncertainty involved. The presence of flexibility makes the estimation of the future cash flows more problematic, and leads us to a different approach, in which we draw an analogy with options in the financial markets, where the investor has flexibility to choose over a period of time whether or not to invest in a certain financial security. Established methods for valuing such options help us value real investments with flexibility. It is clear that flexibility becomes more valuable as uncertainty about the future increases, other things being equal. This makes real options very different from investments without flexibility where uncertainty may reduce value.

A major feature of real option methods is that, not only do they put a value on flexibility, but they also tell us the optimal stage at which to exercise the flexibility. For example, as the market price of the output of a production process falls, it is possible to find the optimal point to stop producing. Of course, the presence of costs to interrupting production and uncertainty over the path of future prices may make it rational to continue producing goods even when costs exceed revenues. Likewise, it may be rational to wait before starting to produce until revenues considerably exceed costs. Such circumstances, in which it is economically sensible to produce even when costs exceed revenues or, in different cases, not to produce when revenues exceed costs, is a typical and important feature (called hysteresis) of many real option situations.