I really want to stress how important the concept of expected value is.
When it comes down to it, one’s ability to accurately (and honestly) forecast expected value is one of, if not the, most important skills we must have as traders.
Let take the example of a small semi-pro baseball club plans to invest $10,000 to host an exhibition baseball game. They expect to sell tickets worth $15,000.
If it rains on the day of game, they won’t sell any tickets and the club will lose all the money invested.
If the weather forecast for the day of game is 20% possibility of rain, is this a good investment?
Bottom Line
We have to identify what our potential profits are, what our potential losses are and the probability of each outcome occurring. If the game goes on as scheduled, the club stands to make $5,000 (the difference between the initial investment of $10k and the $15k gate), if the game is a washout, they will lose their entire $10,000 investment.
We know there is a 20% chance of rain meaning there is an 80% chance that the game will go on.
Crunch The Numbers
Using our trusty expected value calculation (see below), we yield the formula: (.80*5,000)+(-.20*10,000) = 4,000-2,000 = +$2,000. So, this is a good investment with a positive expected value.
Expected Value = Prob. Event A * $ Effect of Event A + Prob. Event B * $ Effect of Event B + …
= = =
