By Steve Papale
I’ve been hanging Christmas lights for a week now. My hero on this is of course Clark Griswold who puts up 25,000 lights on the outside of his house. My approach is a bit different. I hang them on the inside. I figure that way we get to see them all the time. Each year I cover a little more of the house. Not yet to 25,000 but next year I’ll start on the outside.
High probability trades are nice. Putting the statistics in our favor is always a good thing. That is a big part of the edge in our trading. But it is only half the story. The other half is the maximum payoff. The two combined give us our expected payoff. Lotteries have high payoffs but low probabilities. Savings accounts have high probabilities (interest payments) but very low payoffs (interest) – especially these days. So how do we evaluate a particular trade?
Let’s say we have a trade that has a 90% probability of paying me $1. I have another trade that has a 20% probability of paying me $5. Which one has the highest expected payoff? Simply multiply the probability by the payoff. The first is .9 x $1 = $0.90. The second is .2 x $5 = $1. So the second trade has a higher expected payoff. This provides us a lot of information.
What it does not take into account is how much money we need to get into the trade. To determine the expected return we simply divide our expected payoff by how much it requires to get into a trade. If the first trade costs $10 than expected return would be $1/$10 = 10%. This type of calculation can help when evaluating various trades. Other factors such as volatility and risk management will also bear heavily on trade performance.