Kelly criterion

The Kelly criterion is an advanced money management tool that helps you work out how much money you can risk on each new trading position based on how well you have done with similar trades in the past.

One thing you must understand when using the Kelly criterion is that this is a method used for diversification. Traders and investors have different preferences as to how they manage their equity. Some traders will use the Kelly criterion to base an individual trade or investment on, whilst others will use this method to allocate a percentage of their account to a particular sector or industry.

The Kelly criterion is for advanced traders only.

The Kelly criterion is based on your previous trades

It looks at the results of your previous similar trades and gives you a so-called Kelly percentage number. This number tells you what percentage of your trading account you could risk on this kind of trade at the current time.

Calculating the Kelly criterion

Calculating the Kelly criterion is relatively simple and relies on two basic components: your trading strategy's win percentage probability and its win to loss ratio.

The win percentage probability is the probability that a trade will have a positive return. The win to loss ratio is equal to your total trading profits divided by your total trading losses.

These will help you arrive at a number called the Kelly percentage. This gives you a guide to what percentage of your trading account is the maximum amount you should risk on any given trade.

The formula for the Kelly percentage looks like this:

Kelly % = W – [(1 – W) / R]

• Kelly % = Kelly percentage
• W = Win percentage probability (total number of winning trades/total number of trades)
• R = Win to loss ratio (total amount gained by winning trades/total amount lost by losing trades)

An example of calculating the Kelly percentage

The following is an example of how you calculate the Kelly %:

Lets say that you have been trading with a system that has given you 40 winning trades and 60 losing trades.

W = Total number of winning trades/ total number of trades

W = 40/ (40 + 60)

W = 0.4

Calculating R

Over the course of trading your system, your winning trades increased your account by $6000 and your losing trades lost a total amount of $2000.

Your win to loss ratio (R) is worked out as the following:

Positive trade amount/negative trade amount:

R = 6000/2000

R = 3

Calculating Kelly %

The calculation for the Kelly % would then be as follows:

Kelly % = W – [(1 – W) / R]

Kelly % = 0.4 – [(1 – 0.4 ) /3 ]

Kelly % = 0.2 or 20%

This means that you can risk 20% of your equity on a single investment or trade.

Of course, this does not mean that you blindly base 20% of your account on a trade if you are day trading or conducting any kind of short term trading – a series of losses will wipe your account out immediately. However, it may if you are trading or investing long term or help you diversify your investment portfolio and allocate a proportion of your trading equity to certain assets.

When to over-ride the Kelly criterion

It is important not to over-rely on the Kelly Criterion as your sole method of judging position sizes and risk tolerance.

As with all forms of money management techniques and calculations, you should always work out – and stick to – a maximum risk level for any trade, regardless of what formulas like the Kelly criterion tell you.

For example, if the Kelly percentage indicates that you could risk as much as 50% of your account balance on a single trade and you – like most traders – have a much smaller maximum risk level, you should ignore what the Kelly percentage tells you in this instance and revert to your maximum risk as the standard.

How do I know my risk tolerance?

Traders all take a different view on what this maximum standard should be, based on their personal trading strategies and risk tolerance. The most important thing to bear in mind when setting your maximum risk level is how any losses will impact your trading account and how these losses will affect your trading psychology, etc.

For instance, if you have a very high risk tolerance you are likely to risk a greater percentage of your account balance in line with the Kelly percentage. This will result in much higher returns when your trading is successful but much more damaging hits to your account balance when it is not.

If you have a very low risk tolerance you should keep your risk on each trade extremely low, despite what the Kelly percentage suggests. This will result in much smaller profits but also smaller hits to your account balance when trades go wrong.

If ever in doubt, stick to trading with a maximum risk level of 2% of your account.

Base your calculation on 100+ trades in similar market conditions

The more trades you base your calculations on, the more accurate your Kelly percentage is going to be. To start, you should take at least 100 trades into account to make sure that your strategy is profitable.

To use the Kelly criterion, start by logging all your trades in a trading journal, detailing the size, direction, profit target and outcome of each position. Only once you have around 100 similar trades do you have enough data to base your calculations on.

Market conditions play a part in your risk

Also, keep an eye on market conditions. Markets move through various cycles and the same trade will have a very different outcome depending on whether it is placed during volatile, ranging or trending conditions.

If prices are currently trending, for example, and you want to work out how much you can afford to risk on a new position, only include in the Kelly criterion calculation those similar trades that were also taken during trending conditions. This will help to keep your results consistent.

Summary

In this lesson you have learned that:

• the Kelly Criterion is a money management tool that helps you work out how much money you can afford to risk on each new trading position.
• it calculates a Kelly percentage number based on how much profit or loss you have made on similar trades in the past.
• this number tells you what percentage of your trading account you could sensibly risk on this kind of trade now.
• to use the Kelly Criterion, start by logging all your trades in a trading journal, detailing the size, direction, profit target and outcome of each position.
• only when you have at least 100 similar trades logged do you have enough data for the Kelly Criterion to base its calculation on.
• market conditions will affect the outcome of any trade, so make sure that you only include in your calculation trades that were taken during similar market conditions as those in effect now.
• do not over-rely on the Kelly Criterion to judge position sizes and risk tolerance – whatever it tells you, never risk more than your usual maximum risk level.
• if ever in doubt about your risk tolerance, stick to a maximum of 2% of your trading account on anyone trade or investment.