Edge plays as a significant parameter in finance and gambling or in any form of betting games.In Trading and Insurance ,it finds vital applications as the factor which stands between solvency and insolvency of the enterprise.Widely used and the lifeblood .It is just an attempt to refresh.Following description may not be appropriate from moral angle,but good from view point of understanding the concept.
When a six sided dice is rolled,six outcomes are possibility.One is to roll the dice and he receives rupee amount equal to spot number which comes up.If result is one he gets Rs 1 ,for two ,he gets Rs 2 and so on upto six.If one were to roll the dice infinite number of times,what is expected per each roll on average?Yes it is simple calculation -high school math.There are six numbers which can come up having equal probability.Then adding up six possible outcomes from 1 to 6 and dividing it by 6 which is for six faces of dice we get 21/6 equals to 3.5.That is the average we can expect to get each time we roll the dice.This is expected return of this game.If someone were to charge us for a chance to roll the dice ,what might we be willing to pay?If the cost of a chance to roll the dice once is less than Rs 3.5, in the long run we could expect to be winners.If we pay more than Rs 3.5 ,in the long run we could expect to lose.Paying exactly Rs 3.5 ,we tend to break even.This is law of probability.The expected return has to happen only if we roll the dice many many times.If we roll the dice only once we can not get back Rs 3.5 as no face of dice is spotted with Rs 3.5.But if we pay less than 3.5, for even one roll of dice.the laws of probability favours us because our payment is less than expected return.The edge possibly going to work even for one isolated attempt.
The same laws of probability which govern a casino to set the odds for different games ,also enable a trader to evaluate an option and find the edge.It finds application in insurance.By using statistical data and probability theory .the insurance company calculates the probability of claims in future which is factored into expected earnings on premium payments to be collected.That is how theoretical value of insurance policy is arrived at.In options ,theoretical value works as similar benchmark to find edge.Yes Nothing
Now going to casino and the roulette table.Never gone there really ,only seen them in TV .A roulette wheel has 38 slots with numbers from 1 to 36 and two additional slots with 0 and 00.It is like a dice with 38 faces.You only chose a number and if your number strikes you get Rs 36.you get nothing if any other number comes up.Now coming to expected return of this game.There are 38 slots in roulette wheel ,each having equal probability exactly like 38 faced dice ,but only one slut will return Rs 36 to player.So simple high school math here again.No big deal.Out of 38 rolls of dice you get Rs 36 from the laws of probability as there is only one way.So per roll your income going to be 95 Paise.So palyer to break even ,has to pay 95 paise.
casinos can not run and remain solvent if players break even as casino would not make any profit.In practice,the player has to pay more than expected return for the bet.This differential between the cost of bet and expected return is the profit of the casino and is called the EDGE.
The same laws of probability which govern a casino to set odds for different games of chance ,also enable a trader to evaluate option and find edge.Through use of statistical data and probability principles ,the insurance companies attempt to find out the likelihood of future claims which is then factored into their expected earnings from premium payments and theoretical value of insurance policy is arrived at.In options .theoretical price works as benchmark to figure out the theoretical edge.All those insurance policies don’t end up with claims except a few perhaps.some tend to be less and few tends to be very high.Average premium receipt less average payout due to net claims over a period is the edge.
Exactly similar way ,all those option strikes don’t end up in exercises ,only few does and most expire worthless. So average premium receipt less average payout is your edge. Yes nothing new in there, but the beauty of understanding is always marvelous.