Expected value (EV) is the sum of the probability weighted outcomes.
To explain further, let's use a simple example and assume you have five pieces of paper in a velvet bag, all of them numbered 1-5. If you pull any one number, you will have a 20% chance of choosing any of them. (1/5=.2)
To better visualize this concept, let's run some quick math. We have a 20 percent chance of pulling a 1, 2, 3, 4, or 5.
- 1*.2 = .2
- 2*.2 = .4
- 3*.2 = .6
- 4*.2 = .8
- 5*.2 = 1
If we combine all the outcomes we get a total of 3.
Assume we play a game and we charged $3.25 to play. If you pulled a 5 out of the bag we paid you $5. If you pulled a 1 we paid you $1, meaning you lost $2.25 etc. So, would you take that bet?
Since we did the math we knew the EV was 3, but we were charging $3.25 for each pull, so in the long run we averaged +.25 profit a pull. ( .25 cents bought you 1/2 a ramen packet back then btw)
Now let's apply this to Options.
Let’s say we want to buy a 45k call that expires tomorrow. Let’s also say that BTC has a 20% chance of being worth 40k, 42k, 45k, 48k, 50k.
At expiration the 40k, 42k, and 45k will be worth $0. But the 48k will be worth $3k, and the 50k strike will be worth $5k. If we do the math it will look like the following:
- 0*.2 = 0
- 0*.2 = 0
- 0*.2 = 0
- 3,000*.2= 600
- 5,000*.2 = 1000
Sum = 1,600
If the probability weighted the outcome of buying the 45k Call Option is $1,600.
To wrap up, EV is a helpful statistical measure to predict how profitable a strategy may be and can help you determine if the price of an option justifies its risk profile.
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