If you are losing money and doing so over a sample size that makes it likely you’re not simply dealing with the vagaries of the market, then you need to really assess whether the strategy (or strategies) you are using is putting the odds in your favor. Macro Ops assumes no liability for losses incurred from readers trading securities that are mentioned in any of our content. Expected Value (EV) & Bayesian Analysis In Trading, on Expected Value (EV) & Bayesian Analysis In Trading. The best traders keep losses minimal when they’re wrong and make healthy profits when they’re right. Calculating EV before placing a trade is crucial. . A flush will always beat a straight. Either way, we’ll consider at a trade as long as it has a positive EV. What is the Expected Value (EV)? When people wipe out their trading accounts it’s usually due to either excessive leverage, putting too much on any given bet in an all-or-nothing style (e.g., options, binary options), or by selling options. He’ll take this bet any day of the week. Traders tend to use the recent past to inform the future. Let’s say you have a 99% chance of being wrong but your cost of being wrong is $100, and you have a 1% chance of being right but your reward is $100,000. It doesn’t matter if they were objectively good bets. Suppose that the probability of being right is 70 percent and the reward for being right is $50, and the probability of being wrong is 30 percent and the reward for being wrong is $100 (or -$100 to denote the loss of money). Despite our best efforts to predict financial markets, we’ll inevitably be wrong time and time again. In trading, the concept is similar. * This is figured by taking the expected payoff per bet, taking the difference relative the amount wagered per bet, and dividing by the amount wagered per bet. Let’s say we think there’s a 50% chance USDJPY rallies over the next 3 months. For some, it’s a matter of prudent risk management. In such a scenario, the EV is the probability-weighted averageof all possible events. Given the expected value is positive – if you have assessed your probabilities correctly – the expected reward is higher than the expected penalty. To use a baseball analogy, it’s not your batting average that matters (ratio of successful at-bats to total at-bats), it’s your slugging percentage (the overall quality of the at-bats or how much is produced when you are successful). For different traders it means different things. We combat the changing landscape by embracing something called Bayesian analysis, which means we update probabilities and payoffs as new information becomes available. However, if you played this game 200 times with an equal $100 bet each time, you would expect to lose $100 (200 multiplied by the expected loss of -$0.50), or equal to your regular bet size. But it’s important to remember that markets are a continuous event, not a discrete one. Things can unfold that aren’t in your distribution and can’t be priced. There are many unforeseen factors that could derail the trade, but if our original probability and payoff estimates are correct, this same trade will eventually result in net profits when continuously repeated. Back in the 70s and 80s markets exhibited an incredible amount of trending behavior, conducive to trend following strategies. It could take a while to learn that you actually have a bad strategy if you are right on the border between something that’s viable and not any better than flipping a coin. If you have a flight to catch, you’re likely to leave for the airport well ahead of time to give yourself a reasonable time cushion. Therefore, the general formu… All contents on this site is for informational purposes only and does not constitute financial advice. Risk Warning: Trading CFDs on leverage involves significant risk of loss to your capital. For example, in the markets, you will often be confronted with situations where your probability of being right is quite high, but the reward is low and the penalty for being wrong is correspondingly high. Expected value = P(right) * R(right) – P(wrong) * R(wrong). Central banks can decide a currency is too strong and intervene in a moment’s notice. In such a case, the EV can be found using the following formula: Where: 1.