Theoretical Edge Example by Market Chameleon

Let's go over a simplified example of theoretical edge.

Insurance company ABC sells car insurance policies for $1500. How much do they expect to make?

  • 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
    MC Trade card highlighting theoretical value

    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
    Trade Card Theoretical Edge

    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
    MC Trade card highlighting win rate

    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