The significance of mathematical expectation in trading.
In order to be successful in trading, you have to know what is called the expected value of a trade. Before you put capital to work, you should have an idea about what you stand to make or lose BEFORE you actually lose anything. You might consider paper trading: testing some ideas you have and recording whether you bought or sold short, how much capital you put to risk, and where you got out making or losing money.
You can call this your Trade Ledger – a list of all your trades – winners and losers. (If you are using backtesting software, it will do it for you.)
From your Ledger, you can begin to start thinking about mathematical expectation of your trading. This is important to the extent that whether you trade at a Prop Trading Firm or on your own, you’ll need to have a firm grasp on the expected value of a trade. You need accurate records to calculate this.
The significance of the expected value of a trade (based on your market calls) will tell you how much you expect to make on average by trading your set of rules, hunches, tips, or mood ring settings. By knowing this before you put capital to risk, you can save yourself a lot of money.
To get a feel for expected value, consider the following game that is proposed to potential trainees at a very well-run prop trading firm and market maker.
You are invited to play a game that will cost $1 to play. When you win, you’ll receive $100. If you lose, you lose your $1 only. So if you win, you’ll make 100 times your money.
From a deck of 52 cards, you must turn over 2 Aces (any 2 of the 4) in succession off the top of the deck – the first two cards. If you do that, you’ll win the $100. If not, you can try at it again for another $1.
If this was a trade, how frequently would you want to put this trade on? Anyone want to send me the solution?
If you get it right, I’ll publish your name (with your permission) for the kudos. You must send me the math.
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[...] This post was mentioned on Twitter by Michael Martin, Winfield Russell. Winfield Russell said: RT @Martin_Kronicle: Prop Trading Firms & Expected Value: To trade successfully, you have to know the expected value .. http://bit.ly/8iFoVM [...]
I would never put this trade on.
This is not a trade, it's a gamble.
Well done!
Oops Michael asked for Math. This reminds me too much of school Michael ;)
So I did a probability intersection of two events.
Event A is odds of picking an ace out of 52 cards (4/52).
Event B is odds of picking a SECOND ace out of 51 cards (3/51)
Intersection probability formula is P(A) * P(B). Which gives us .00452489 * 100 or .45 percent chance to win $100. So we're paying $1 a pop to win $100 yet we don't win at least $100 every 100 times we attempt this so it is not even break-even, it is a negative expectancy proposition.
I would never put this trade on.
This is not a trade, it's a gamble.
Well done!
[...] Expectation Of A Trade January 20 2010 | 3:22 am PST ShareI received a lot of emails to my post yesterday about the expected value of a trade. Only one person got the correct answer to the game of flipping 2 Aces off the top of the deck [...]