Expected Value in Investing

Basic odds calculations to guarantee a long term return

Written by: Zack | zack@randomstock.net

Key Points

• Determine the percent chance of a successful trade based on your analysis (say 10%)
• Determine the return of the trade in question (e.g. 50\$ profit on a \$50 investment)
• Compute whether your trade will win in the long run: if you win \$50 in 1 out of 10 and lose \$50 in 9 out of 10, your trade has an expected value of \$-400

Determining Percent Chance of Successful Trade

How do you compute the chance that your trade will succeed? Ah! Therein lies the rub. Well, one method is to look at a specific type of trade, say: selling an options trade. A study in 1990 (yes a long time ago, lol) showed that ~75% of options trades expired worthless. Now I'm not saying this is iron clad truth, but you could test it's accuracy yourself. Check and see if 75% of the options trades you sell are winners. I recognize determining a percentage of success is difficult, and this is the skill of the trade. However, if you follow these rules and find you are losing money in the long run, that means you're not making odds correctly.

Percent Return Weighed Against Percent Profit

You have found a trade that you think has a success rate of 25%, meaning 25% of the time you win and 75% of the time you lose. In order for this trade to be a winner for you, the return must be > 300%. Meaning you'd need to make more than \$300 profit on a \$100 dollar investment. Let's look at it play out over 100 trades: If you win \$300 25 times, you've just made \$7500, if you lose \$100 75 times, you've just lost \$7500 giving an expected value of \$0. Now lets say that you can make a 400% profit on the trade with a 25% success rate. Now you can make \$10000 on your 25 winning trades and you only lose \$7500 on your 75 losing trades, your expected value is \$2,500.

Conclusion

These are the same type of calculations casinos undertake to make sure that in the long run, they make a profit. It's much easier in the casino business because the probability of success (chances of a jackpot, blackjack, roulette win) are known. This principle can be adopted in the investing world, the only unknown is determining probability of success. This is where your skill and analysis come into play. Beware of anyone who says they can calculate the probability of success with a blackbox application. Actually beware of most trading coaches, trading algorithms, and trading platforms.

-Zack