Expected value (EV) lies at the core of successful trading. It refers to the concept of consistently achieving more profits than losses in trading to achieve profitability over the long term. If you are looking for a complete guide on all aspects of trading check out the article here.
In this article, we will deep dive into Expected value and discuss :
1. A full theoretical explanation of EV
2 . A practical example to better understand it
3. Positive Expectancy’s crucial role in trading
4. Traders expectation with positive EV
5. The risk of ruin
Lets jump right in.
Explanation of Expected Value
Expected Value is a statistical measure that determines the expected outcome of a random variable after a certain number of occurrences. It represents the long-term average outcome or result that we can anticipate based on the probabilities associated with different outcomes.
When there are investment risks, it is important to design an investment strategy with long term positive expected value (EV). This way, over a long period of time, the strategy can expect to bring in a profit. Additionally, a positive EV mitigates the risk of ruin or material financial losses (more on this later). The age old saying of the casinos is “the house always wins”. This is because casinos understand the concept of positive EV and use it to have the odds in their favor.
Example of Positive Expected Value
Now that you understand EV is a statistical variable for how much money a strategy can make, let’s wrap our heads around it with an example. Consider a simple example using 10 coin tosses. Let’s assume that for each successful coin toss, you win $2, while for each unsuccessful toss, you lose $1. Even though the outcome of each individual coin toss is random, over a series of 10 tosses, you are likely to end up with a profit. In a perfect world, you would win 5 tosses and lose 5 tosses. Therefore, your statistically expected profit would be ($2 × 5) – ($1 × 5) = 5$. A simpler way to express this is that out of 10 coin tosses you win 5$ or 0.50$ per coin toss on average. The value you can expect per coin toss (or the EV) is 0.50$.
The above equation can be used to calculate the EV. In the case above the Win%=50% or 0.5 ; The winning payout is 2 ; the Loss% is 50% and the losing payout is 1. So if you plug these numbers in you get EV = 0.50$.
Positive Expectancy’s crucial role in trading
Positive expectancy is the foundation of consistent profitability in trading. It allows traders to overcome inevitable losses and generate sustainable gains over time. A trading strategy with a positive expectancy provides a statistical edge, giving traders confidence and discipline to stick to their strategies even during periods of short-term losses.
EV of a trader should be periodically measured and used as a gauge for overall performance. It should also be looked at as a measure for performance to find ways to improve results [link].
What to Expect When Striving for Positive Expectancy
Traders aiming for positive expectancy should expect a mixture of winning and losing trades. It is also important to note that no matter what time frame you trade there will always be some form of patience required to find the right opportunity.
Sometimes there will be days or even weeks (depending on the timeframe you trade) where there are no profitable trades. It is important to wait for these setups and not deviate away from your winning strategy. It is crucial to focus on the overall performance of the strategy rather than individual trades especially when there are drawdowns [link] .
Losses are an inherent part of trading, but as long as the strategy maintains a positive expectancy, profits should outweigh losses over a larger sample of trades.
The Risk of Ruin
While positive expectancy is essential for sustainable trading success, it is important to address the risk of ruin. The risk of ruin refers to the possibility of depleting your trading capital to a point where recovery becomes extremely challenging or even impossible.
For instance, let us say you have a coin toss scenario where the odds are 50% and the payout is 3:1. You have a 10$ bankroll and you decide to bet all 10$ on the first flip. In that instance there is a 50% probability of losing your entire bankroll (risk of ruin). Let’s say instead you bet half your bankroll 5$, the odds of you losing everything are losing 2 coin tosses in a row which are 25%. The smaller the bet size the lower your risk of ruin will be if the EV is positive. This same concept applies in trading. For a good reference of risk size check out the article on risk management.
One thing to note is that if the probabilities of a random outcome are less than 100% and you bet your entire bankroll, your EV will always be negative so position sizing is key.
To mitigate this risk, traders should implement effective risk management techniques, such as proper position sizing, setting stop-loss orders, and maintaining a diversified portfolio.
Conclusion
Positive expectancy is the cornerstone of successful trading, providing traders with the statistical edge needed for consistent profitability. By understanding and implementing strategies that generate positive expectancy, traders can overcome profit long term. It is crucial to manage risk effectively and stay disciplined to mitigate the risk of ruin. Remember, trading is a marathon, not a sprint. Focus on maintaining positive expectancy over a significant sample of trades, and you will increase your chances of sustainable success in the dynamic world of financial markets.
Be sure to check out more articles for more information on risk management and let me know what else you would like to learn about.
Trade Safely!
Andrew Akl
WealthGrasp.com adheres to strict editorial integrity standards. To the best of our knowledge, all content is accurate as of the date posted, though offers contained herein may no longer be available. The opinions expressed are the author’s alone and have not been provided, approved, or otherwise endorsed by our partners.Information provided on WealthGrasp.com is for educational purposes only. Your financial situation is unique and the products and services we review may not be right for your circumstances. We do not offer financial advice, advisory or brokerage services, nor do we recommend or advise individuals or to buy or sell particular stocks or securities. Performance information may have changed since the time of publication. Past performance is not indicative of future results.
