December 6, 2017

Money Management Using The Kelly Criterion

The Kelly criterion is a formula used to determine the optimal size of a series of bets in order to maximise the logarithm of wealth. In recent years, Kelly has become a part of mainstream investment theory and the claim has been made that well-known successful investors including Warren Buffett and Bill Gross use Kelly methods.

• Win probability - The probability that any given trade you make will return a positive amount. 
• Win/loss ratio - The total positive trade amounts divided by the total negative trade amounts.

These two factors are then put into Kelly's equation: 
Kelly % = W – [(1 – W) / R]

Where: 
W = Winning probability 
R = Win/loss ratio = value of profitable trade/ value of loss making trade

Example: say you are winning 60% of the time and your Win/ Loss ratio is 1.5. Then you should invest:

= 0.6-[0.4/1.5]=0.33 or 33% of your capital on a trade.

Another example: say you are winning 20% of the time and your Win/ Loss ratio is 5. Then you should invest:

= 0.2-[0.8/5]=0.04 or 4% of your capital on a trade.

Last example: say you are winning 50% of the time and your Win/ Loss ratio is 2. Then you should invest:

= 0.5-[0.5/2]=0.25 or 25% of your capital on a trade.

NOTE: I am risk averse and prefer capping investment per trade at 5% of capital.

Read more at https://www.investopedia.com/articles/trading/04/091504.asp





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