Kelly Criterion Money Management
The Kelly Criterion or Kelly’s formula is about minimizing losses and maximize your gains through efficient diversification. The Kelly Criterion is one of many models that can be used to help investors & traders with a diversified strategy. There is a maxim applied to investing; don’t put all your eggs in one basket. So Kelly’s formula helps to derive a diversification strategy. Put simply, it is used by traders, gamblers, and investors to determine the optimal size of bets so as to devise a formula to maximize profit and limit risk.
How successful is the Kelly Criterion?
In most gambling scenarios and some investing scenarios, in a less complex environment, the Kelly strategy will tend to outperform any different strategy in the long run
The world top investors, including Warren Buffett and Bill Gross, use the Kelly Criterion.
The Kelly’s formula is currently part of mainstream investing.
What then is Kelly Criterion?
The two basics components of the Kelly’s formula are as follows;
• 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 (or variables) are then put into Kelly’s equation:
Kelly % = W – [(1 – W) / R]
W = Winning probability
R = Win/loss ratio
Kelly Criterion can be used by following these steps
1. Access your last 50-60 trades. You can do this by simply asking your broker, or by checking your recent tax returns (if you claimed all your trades). If you are a more advanced trader with a developed trading system, then you can simply back test the system and take those results. The Kelly formula assumes, however, that you trade the same way you traded in the past.
2. Calculate “W”, the winning probability. To do this, divide the number of trades that returned a positive amount by your total number of trades (positive and negative). This number is better as it gets closer to one. Any number above 0.50 is good.
3. Calculate “R,” the win/loss ratio. Do this by dividing the average gain of the positive trades by the average loss of the negative trades. You should have a number greater than 1 if your average gains are greater than your average losses. A result less than one is manageable as long as the number of losing trades remains small.
4. Input these numbers into Kelly’s formula: K% = W – [(1 – W) / R].
5. Record the Kelly percentage that the equation returns.
Interpreting Kelly Criterion results and how to use it.
The K% equals the size of the positions traders should be taking. For example, if the Kelly percentage is 0.05, then that trader should take a 5% position in each of the equities in portfolio. In short, Kelly Criterion gives traders/investors an idea of how much they should diversify in their portfolio.