Kelly Criterion: Introduction to Trading
Financial market trading is interesting and rewarding. However, a clear approach is needed to reduce risks and maximize revenues. Developed by mathematician and physicist John L. Kelly Jr., the Kelly Criterion is a popular trading method. The Kelly Criterion and trading applications are explained in this essay for beginners.
Understanding Kelly Criterion
A hazardous investment’s optimum capital allocation is calculated using the Kelly Criterion. It considers investment return, success likelihood, and cash availability. The algorithm helps traders determine position size and trading capital allocation.
In essence, the Kelly Criterion seeks to maximize benefits and minimize losses. Calculating the ideal position size helps traders avoid making huge wagers that might wipe out their wealth.
Kelly Criterion calculation
Kelly Criterion formula is simple:
Kelly %= (Probability of Success x Reward – Failure x Loss)
Break down this formula’s parts:
Probability of Success: A trade’s profitability.
Reward: Trade profit possibility.
Probability of Failure: Trade loss probability.
Trade loss or risk.
All Kelly Criterion probabilities should be decimal (e.g., 0.7 instead of 70%).
Traders may compute the best position size as a percentage of their capital by entering the values. Trade allocation should be this proportion.
Trading using the Kelly Criterion
Now that we know how the Kelly Criterion is determined, let’s apply it to trading. Suppose a trader has $10,000 and finds a transaction with a 60% chance of success, a $5,000 payout, and a $2,000 loss.
Calculate the ideal position size using the Kelly Criterion formula:
(0.6 x $5,000) – (0.4 x $2,000) = $3,200
The trader should invest $3,200, or 32% of their money, in this deal.
Note that the % is the best position size depending on inputs. However, traders may modify position size based on risk appetite and preferences.
Kelly Criterion limitations
While the Kelly Criterion might be useful in trading, it has limits. Real-world trading situations seldom assume complete knowledge of future success and failure rates, which is a severe problem. Market circumstances change, and probability are estimations based on previous data or technical analysis. Therefore, the Kelly Criterion should be a recommendation rather than a rule.
The Kelly Criterion implies traders know each trade’s prospective profits and dangers, which may not be true. It is difficult to predict trade outcomes with accuracy. Thus, traders should utilize the Kelly Criterion cautiously and in combination with other risk management procedures.
Conclusion
The Kelly Criterion helps traders improve position size and risk management. It’s not perfect, but it helps determine the best capital allocation depending on performance, reward, and loss. Using the Kelly Criterion alongside other risk management approaches may help traders succeed in the turbulent trading industry.
References and sources:
1. Investopedia: https://www.investopedia.com/terms/k/kelly-criterion.asp
2. Forbes: https://www.forbes.com/sites/peter-j-reilly/2015/06/03/phil-ipps-on-how-the-kelly-criterion-can-help-your-investing/#3159d6396cde
3. Wikipedia: https://en.wikipedia.org/wiki/Kelly_criterion