#TradingInterview #ProbabilityInTrading #TradingStrategies #RiskManagement #ProbabilityAnalysis
📊 How would you answer this trading interview question?
When it comes to trading, probability plays a crucial role in making informed decisions. The ability to assess the likelihood of certain outcomes is essential for successful trading. In this article, we will delve into the concept of probability in trading and how it can be applied to make more informed investment decisions.
## Understanding Probability in Trading
In trading, probability refers to the likelihood of a certain event occurring. This could range from the likelihood of a particular stock reaching a certain price level to the probability of a trade resulting in a profitable outcome. By understanding and analyzing probabilities, traders can make more calculated decisions and manage their risk effectively.
## Using Probability in Trading
When faced with the question of whether to buy a painting with an 80% chance of being fake, traders can apply probability analysis to make a rational decision. In this scenario, the potential outcomes are as follows:
– If the painting is real, it’s worth 500k
– If the painting is fake, it’s worth 10k
Based on this information, the expected value (EV) of purchasing the painting can be calculated using the following formula:
EV = (Probability of the painting being real * Value if real) + (Probability of the painting being fake * Value if fake)
EV = (0.20 * 500k) + (0.80 * 10k)
EV = 100k + 8k
EV = 108k
With the expected value of purchasing the painting calculated at 108k, which is higher than the asking price of 120k, it may not be a favorable trade based on probability analysis alone.
## Trading Options Using Probability
In trading, probability analysis is not only applicable to individual trades but can also be used to shape trading strategies and risk management. By considering the probability of success for each trade, traders can make more informed decisions and manage their positions effectively.
For example, a trader may implement a strategy that only takes trades with a probability of success of 70% or higher. This ensures that a greater proportion of trades are likely to result in profit, ultimately contributing to a more successful trading approach.
## The Importance of Probability in Trading
Before incorporating probability analysis into trading, it’s essential to assess your proficiency in understanding and applying probability. Having a good grasp of probability concepts and the ability to calculate and interpret probabilities will be advantageous in making sound trading decisions.
## How Much Probability is Required?
The level of probability required in trading can vary depending on individual risk tolerance, trading strategy, and overall trading objectives. However, as a general guideline, aiming for a probability of success of 70% or higher can be a favorable approach for many traders.
## Final Thoughts
In conclusion, probability analysis is an invaluable tool in trading, allowing traders to make more informed decisions and manage risk effectively. By understanding the probabilities associated with each trade and implementing strategies based on probability analysis, traders can increase their likelihood of success in the markets.
Incorporating probability analysis into trading requires a good understanding of probability concepts and their application in a trading context. By honing your skills in probability analysis, you can enhance your trading prowess and make more informed investment decisions.
Is trading option using probability on every trade? How much probability is required anyway? It’s important to note that while probability analysis can help inform trading decisions, it should not be the sole basis for making trades. Other factors such as market analysis, technical indicators, and risk management strategies should also be taken into account when executing trades.
Before taking the step to incorporate probability analysis into your trading approach, it’s important to assess your proficiency in probability and determine how comfortable you are with integrating this analysis into your trading strategy. Ultimately, understanding and applying probability in trading can significantly enhance your trading prowess and contribute to more successful investment outcomes.
By utilizing probability analysis in trading, you can make more calculated decisions and increase the likelihood of profitable outcomes. As you continue to refine your skills in probability analysis, you’ll be better equipped to navigate the complexities of the financial markets and make informed investment decisions.
In summary, probability analysis is an essential tool in the trading arsenal, providing traders with valuable insights into the likelihood of certain outcomes and enabling them to make more informed decisions. Through a solid understanding of probability concepts and their application in trading, you can enhance your trading approach and increase your potential for success in the markets.
80%*10k plus 20%*500k is 108k expected value, lower than asking price. don’t buy
I’d answer it by calculating what the expected value of that deal is over the long run. Let’s assume you can buy this painting several times over.
On average, 80% is fake which means 1 in 5 are real, meaning you have a 20% chance for it to be worth 500k. Assuming fakes are worth $0, this means the expected value of the painting deal is 100k (500*.20)
If you keep buying this painting over and over you will lose, on average, 20k every time you purchase a painting. So no, I would not buy it.
At the price of 120k, a real painting needs to be worth at least 600k to break even in the long term. At values over 600k, the deal is profitable on average.
Expected value of the painting is 0.2x500k+0.8x10k=108k < 120k, so it’s not worth it.
(unless your utility curve is convex that is🤓)
Tell them yes because you like to take risks. Tell them if it is fake you’ll find some other sucker who will pay $120k to play this same stupid game, if it’s real you’ll sell it for $500k.
Here’s what I’d do.
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Call the insurance company which insures this painting and ask them, as the prospective buyer, to walk you through their authentication process. I then get a second opinion from a competitor insurance company on the authenticity of the painting before I purchase it.
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The insurance companies have the best forensics expert detectives and mot expensive specialists. I PROMISE YOU, that you won’t be able to out-do them.
Calculate the expected value
The expected value that everyone is spelling out in the comments is the correct first step. If i were interviewing tho, i would ask what the EV would have to be for you to make the trade. The interesting observation there is that it’s not that you should just do every positive EV trade, but that the degree the EV is positive needs to exceed your cost of capital / opportunity cost.
If there was any chance the painting is real, the seller would not be selling it for $120k. They would have (should have) verified it themselves. It is the same thing as junk cars (“Lemons”), you can search information asymmetry for additional readings.
Just calculate the expected value for a discrete distribution so in this case ( Prob1*Outcome1)+(Prob2*Outcome2) so ( 0.8 *10k) + ( 0.2 * 500k) this comes out to 108k so you wouldn’t buy it at 120k
Priced at $120k will yield -$12,000 expected value. EV = (0.8*10,000) + (0.2*500,000) = $108,000 Dont buy
bro this is easyy come on
No (expected value < price) although (bonus points mode)…
I’d ask the seller to justify their price. As the prior owner of the asset, they know the odds better than I do, so what asymmetric information can they share that would influence my valuation?
Flip side: If they offer it cheap, how do I know it isn’t a fraud (given insider data)?
Someone is interviewing at SIG
If you can’t answer this question, do not pursue a career in trading, especially in option trading
This is a genuine advise, no offence really
there are a lot of very nice people on this thread op let’s put it this way
Okay is nobody asking why a seller would sell a painting supposedly worth 500K for 120K? 😂 I mean obviously use the expected value formula to answer the question but I would add some humor to the answer and say you are getting scammed regardless if the seller is lowballing you like that
This is middle school – high school math, no? I know this might seem unnecessarily cruel – but you will never be a trader or even near trading. Start evaluating your options (no pun intended).
No. The probability of it being fake is 80%; higher than it being real so why risk it.
No. 500k*.2+10k*.8-120k = -12k expected value of profit
Calculate EV. If less than 120k, then no. If greater than 120k, then yeah. If returnable, then always yes. If non returnable and there’s a market for this type of trade under same conditions, then yes but only if I can sell it for greater than 120k.
No, I’d offer $75K for it for a 30% discount on my rough valuation of $108K
Real world probability expected value question like others said. Honestly not a great question for a trading interview given financial instruments are priced to satisfy no arbitrage conditions I.e. risk neutral probabilities… so a situation like this isn’t particularly relevant, unless it’s just supposed to be a “brain teaser” thing.
also be aware that this doesnt account for risk, lets change the question a bit.
You have two options:
1) flip a coin, heads you get $100, tails you get $0
2) Get $50
Should you do 1 or 2 or be indifferent?
some people would say you are indifferent because the expected value is $50 in each scenario. But, scenario 1 is more volatile and therefore would have a less competitive sharpe ratio
No it’s 108k
would buy.
if its real, cash in for 500k.
if it’s fake, trying to sell for 120k to next person and tell him there’s a 80% chance of being fake.
I’m not pursuing trading but I will say this. There are equally as many rude people in this sub as there are nice people ready to help you. I’ve even seen some comments say don’t pursue trading if you require help with such a “basic” question. These aren’t reality checks. It’s rude people trying to belittle you to feel superior. Ignore them, keep filling gaps in your knowledge and you’ll be fine