Theoretical Edge Example by Market Chameleon

• Run a historical analysis

  Let's say company ABC issued 1000 insurance policies to 1000 people in the last 3 years. Out of 1,000 policies there were a total of 100 claims and the insurance company had to pay out $1 million on those claims.
  What was the average payout per policy?

  Description	Data	Note
  Policies issued	1,000	3 years of historical data
  Total payout at end of policies	$1,000,000	on 100 claims
  Average payout per policy	$1,000	$1,000,000 in payouts / 1,000 policies issued

  Conclusion, the long-term average value or break-even per policy is $1,000. This is the theoretical value.

  How this looks on the Market Chameleon Trade Card

  

  The Theoretical Value

  The theoretical value is displayed to the right of the current market value. Making it easy to see where the current market is pricing the trade vs the value that has been compiled and calculated from historical data.

• Calculate the Theoretical Edge (Expected Return)

  If company ABC sells policies for $1,500, then they expect to make $500, on average, in the long run (based on historical results).
  Calculate the Average Profit

  Description	Data	Note
  Market Price	$1500	Avg Premium Per Policy
  Theoretical Value	$1000	Avg Payout
  Theoretical Edge	$500	Avg Profit

  How this looks on the Market Chameleon Trade Card

  

  How it's Calculated

  Find your edge in terms of capital	1.36 Market Price You receive a [Credit], which means you are selling the Bull Put Spread. 1.77 Theoretical Value 0.41 Theoretical Edge $ In terms of your capital, the difference between the market price and theoretical value.
  Find your capital at risk	1.36 Market Price The Market Price, which, in this case, is the credit you would receive by selling this spread. $1.36 Risk The capital that you are risking.
  Finally, the Theoretical Edge (in terms of percent of capital at risk) calculation	Theoretical Edge / Capital at Risk 0.41 / 1.36 = 30.2%

  The Theoretical Edge

  The theoretical edge is perhaps the most important section of the trade card, this is where you can find how much theoretical edge you have based on calculations from historical data. Just like in the insurance company example, this is the expected average return per trade in the long term (assuming the historical price return distributions of the stock are the same in the future).

• Calculate the Win Rate

  Table for calculation

  Description	Data	Note
  Policies Issued	1,000
  Claims	100
  Win Rate	90%	(1000 policies - 100 claims) / 1000 policies

  How this looks on the Market Chameleon Trade Card

  

  The Win Rate

  The win rate simply shows you the percentage of times this type of trade was profitable over a 6 year historical time frame. If you think of each trade card as a policy, then the win rate would show you how many times the policy expired without a payout on a claim.

• Watch the video to find out more about theoretical edge