No strategy stands the test of time without producing positive expected value…even if you’re Warren Buffett. The problem is traders confuse getting lucky or a hot streak with a repeatable strategy. Trust me – they aren’t the same thing. But can you tell the difference?
I fell into this trap when I first started trading during the dot.com bubble. The market was so buoyant that even bad strategies turned a profit. There was even an experiment where monkeys picked stocks…and beat the market!
Unfortunately, it lulled me into a false sense of security. After the market crashed, I stuck with a strategy that didn’t produce a positive expected value.
Expected value tells you what your trade should return if you repeat it over and over. The critical component here – repeating the trade. That’s why you need to trade small and often. Otherwise, one single trade can demolish your account, even if it had a 90% chance of success.
I trade multiple strategies in my Total Alpha service. But no matter what, ever single trade must yield a positive expected value.
Don’t worry. It’s simple to calculate and easy to incorporate.
This simple formula provides invaluable insight into your trading strategy…probably more than any other metric.
As I mentioned previously, the expected value tells you the return for that trade on average. That doesn’t mean you will get that exact return every time. In fact, it’s likely you never get the exact amount. But if you repeat that same trade over and over…then average the outcomes…you get near the expected value.
You need three components to calculate expected value: win rate, winning outcome, and losing outcome.
Expected value weights the values of the outcomes based on the likelihood of that outcome (IE the win/lose rate).
- A value below 0 means your strategy will lose money over time.
- A value equal to 0 means your strategy will breakeven over time.
- A value greater than 0 means your strategy will make money over time.
The formula is as follows.
Expected Value = (% odds of a win x potential profit) + (% odds of a loss x potential loss)
Note: The chances of losing is 100% – Win Rate. Also, losses are always negative numbers.
Let’s use an example from my Total Alpha portfolio last week.
In this trade, I sold a credit spread in Netflix (NFLX).
- I received a $2.30 premium for the sale, the maximum amount I could win on the trade.
- The maximum potential loss would be the difference between the strike prices less the premium I received.
- In this case, I sold the $310/$315 strikes
- That makes my maximum loss $315 – $310 – $2.30 = $5.00 – $2.30 = $2.70
Now I need my win rate. There are a few ways to figure this out. The most common is to look at your results from your trade journal on similar trades.
Another choice is to look at the option probabilities provided by your trading platform. You look at the probability for the lower strike price (in a call spread-high strike price in a put spread) landing out-of-the-money at expiration.
Here’s a snapshot of an option chain in a trading platform. I’ve pointed to the probabilities I’m referring to.
I went with my typical win-rate on these trades, which is around 65% when I let them expire at full profit.
Now, let’s plug that into the equation and see what we get.
Expected Value = (65% x +$2.30) + (35% x –$2.70) = $1.495 – $0.945 = $0.55
That means I should make $0.55 on this trade over time if I repeat it over and over on average. However, each individual trade will produce results of $2.30 profit or $2.70 loss.
Professional notes about expected value
I provided a very basic explanation of how the expected value works. It gets you started in the right direction. But, if you’re a quick study, then let me give you some additional insights.
- Multiple winning or losing outcomes are possible – I simplified things down to a binary win or loss. The truth is that many outcomes are possible. You achieve partial profit by expiration or partial loss. Each outcome has its own percentage. The trick is to make sure you don’t overlap in your outcomes.
- Don’t figure out your win rate with real money – New strategies should be thoroughly tested. You can program backtests, look through historical charts, or take simulated trades.
- Keep your trades small – The key to making this all work is to trade often. That means you need to trade small. Otherwise, even a 90% chance of success trade can blow up your account.
More trades and more excitement
I’m really excited for what’s to come. I took member feedback and started incorporating different strategies into my Total Alpha service. Now there are trades to suit each person’s tastes.
Total Alpha teaches you how to trade multiple option strategies from beginner to advanced. It’s a great way to learn how to trade profitably.