Expected Value Theory

Expected Value Theory is something that every trader needs to be aware of.  I learned about the principle through my mentor, who is also an avid poker player.

My formula for EV is:

Wikipedia says:

“In probability theory the expected value of a random variable is the sum of the probability of each possible outcome of the experiment multiplied by the outcome value (or payoff). Thus, it represents the average amount one ‘expects’ as the outcome of the random trial when identical odds are repeated many times.”

EV is the difference between the probability of winning or losing multiplied by how much you will win or lose in each bet/trade.  Like trading, poker is a game where probabilities are calculated based on all of the available imperfect information.  Unlike poker, taking on risk in financial markets involves a far more complex system and less reliable information.  Nonetheless, EV is still a solid way to think about trading opportunities.  It forces you to recognize that each individual trade outcome isn’t as important as the overall positive EV because large numbers will eventually play out.  No matter what anyone says estimating EV is just that, an estimate, since every trade is unique and based on current (imperfect) information.  Fat tails exist.

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