The concept of expected return is critical for options traders to understand. The expected return is known as the weighted average outcome. The math is really simple and can be shown as follows; say you were considering an investment that had a 25% chance of a 20% return, a 25% chance of a 10% return, a 25% chance of a 5% return and a 25% chance of a -5% return. The formula would look like this;
Expected Return = (0.25) (0.2) + (0.25) (0.1) + (0.25) (0.05) + (0.25) (-0.05) = 7.5%
As an options trader or if you use options to reduce risk and enhance return on your investment portfolio you need to get in the habit of using an option calculator and calculate the expected return on any position that you are considering. Options without an expected profit should not be used. Scan the market for strategies that have a positive expected return.
Say for example someone challenges you to a game of coin toss. You can pick heads or tails and you can play as long as you wish. If the payout was the same for either heads or tails say $1, there is no statistical advantage to the game and no reason to play. Now if you were the receive $2 when you won and only had to pay $1 when you lost, you’d have a huge statistical advantage and should play that game as much as you can.
Casino games are like the above example but the casino gets $1.05 when it wins and you get $.95 cents. When trading options, use an expected return calculator, find trades where the expected return is on your side and manage your risk always.