The Kelly Criterion investing formula helps determine how much money to invest in each trade to maximize wealth over time while minimizing potential losses. Unlike basic rules, the Kelly formula considers the probability of a trade’s success or failure, helping traders make more accurate decisions based on market performance.
Understanding what the Kelly Criterion is and how to evaluate probabilities is key to applying it effectively. When used correctly, the Kelly Criterion can improve risk management and help achieve higher long-term profits.
What is the Kelly Criterion in trading? In this article, we take a closer look at how to apply the Kelly Criterion in trading, along with its main advantages and disadvantages.
The article covers the following subjects:
Major Takeaways
- The Kelly Criterion is a mathematical formula used to find the optimal fraction of capital to allocate to a position. It helps increase long-term profit margins and reduce the risk of losing initial wealth.
- Experienced investors use the Kelly Criterion as a position sizing strategy to determine the fraction of their capital to allocate, based on their investment strategy. This method allows for faster capital growth while controlling risk exposure and avoiding large drawdowns.
- To apply the Kelly Criterion in trading, consider your trading success rate — how often your trading system generates profitable and losing trades. Then enter these numbers into the Kelly formula, and it will show the optimal value of your investment size.
- The Kelly Criterion is a useful tool for portfolio optimization and capital allocation, helping distribute funds among assets based on expected returns and risk.
What is the Kelly Criterion in Trading?
The Kelly formula, developed by John Kelly at Bell Labs in 1956, was originally designed to help gamblers make smarter bets. The idea was to determine how much money to risk — not so little that you miss a winning chance, but not so much that you go broke.
Over time, this principle moved into the world of finance. Today, traders use the Kelly Criterion to decide what fraction of their capital to invest in a specific trade. The main goal is to find a balance between potential risk and reward and to maximize log wealth growth.
Here’s how it works: the Kelly Criterion formula uses the success probability, the expected profit, the possible loss in case of failure, and the riskreward ratio for each trade to determine the optimal fraction of capital to invest. This strategy helps investors achieve maximized profit over the long run.
Of course, the Kelly Criterion is not a 100% guarantee of success. To make it work, you must accurately estimate the probabilities of different outcomes and the potential returns — not an easy task, given market volatility.
Still, applying this method allows traders to manage risk more consciously, move toward steady capital growth, and avoid both over-leveraged and overly cautious strategies.
Why Professional Traders Use Kelly Criterion for Position Sizing
Professionals often use a Kelly Criterion calculator to calculate how much to allocate per trade. It helps them manage money efficiently and achieve a higher profit percentage over time.
Unlike those who rely on intuition or use a fixed percentage of their capital, the Kelly formula offers a clear, mathematically based position sizing strategy.
Using the Kelly Criterion helps traders avoid two common mistakes: first, risking too little and missing out on high-probability profits; second, risking too much and losing funds due to a drawdown. The Kelly Criterion provides the optimal balance between these extremes to maximize returns.
It's important to note: the Kelly Criterion can be adapted to different strategies and market conditions. The formula considers the probability of success and the amount that can be gained or lost. Traders can adjust their fractional Kelly positions based on their confidence level and market volatility.
Proper use of the Kelly Criterion requires understanding its principles and adapting them to real trading conditions. It’s not a universal solution, but it’s often applied for portfolio optimization and management. Traders should remember that the Kelly Criterion is just one of many factors in investing, and it should be used alongside other forms of technical analysis, capital allocation, and common-sense risk management.
Kelly Criterion Formula Explained: The Mathematics Behind Optimal Trading
The Kelly Criterion formula is expressed as:
f = (bp − q) / b
Where:
- f – the fraction of capital to invest in a trade.
- b – the win ratio (the relationship between potential profit and potential loss).
- p – the probability of a successful trade (expressed as a decimal).
- q – the probability of failure (1 − p).
Successful Kelly Criterion trading depends on several key points. This method requires fairly accurate estimates of two factors: the probability that your trade will be profitable and the ratio of potential gain to potential loss.
If these estimates are inaccurate, the result can be worse than expected and may even lead to losses. The challenge is that, in real life, where asset prices depend on many market factors, predicting these parameters precisely is difficult.
Nevertheless, despite these challenges, the Kelly Criterion remains a valuable tool for smart capital allocation. It helps traders systematically analyze risk and potential reward in each trade.
Many experienced investors use modified or constant fraction versions of the Kelly Criterion, adjusted for specific strategies, risk levels, and current market conditions.
How Kelly Criterion Trading Works in Practice
Suppose you have a trading strategy and want to calculate the optimal position size using the Kelly Criterion. Let’s look at a few real-life examples of applying the Kelly Criterion in investing.
Stock Trades and Probability Analysis
Imagine you analyze Apple Inc.’s stock and estimate a 60% chance of making a profit if you buy now (p = 0.6).
Therefore, the probability of loss is 40% (q = 0.4).
Your analysis shows that if you are right, the gain will be 50% of your trade (b = 0.5).
Applying the Kelly formula:
-
f = (0.5 × 0.6 – 0.4) / 0.5 = (0.3 – 0.4) / 0.5 = –0.2
The result is negative. According to the Kelly Criterion, you should avoid this trade because the risk of loss or drawdown is too high.
Futures Trading and Technical Analysis
Now, suppose you use technical analysis when trading Brent futures. Your trading system shows a 70% probability of success, with an average profit of 80% of the invested capital (b = 0.8). The probability of loss is 30% (q = 0.3).
Applying the Kelly Criterion formula:
-
f = (0.8 × 0.7 – 0.3) / 0.8 = (0.56 – 0.3) / 0.8 = 0.325
In this case, the Kelly Criterion recommends investing 32.5% of your capital in this trade and using an optimal level of leverage.
Options Trading and Risk Consideration
You are considering buying a call option on Alphabet Inc.‘s stock. You estimate a 55% chance that the stock price will rise by the expiration date. The probability of loss is then 45% (q = 0.45). If your forecast is correct, you will gain 200% of your trade (b = 2).
Applying the Kelly Criterion formula:
-
f = (2 × 0.55 – 0.45) / 2 = (1.1 – 0.45) / 2 = 0.325
In this case, the Kelly Criterion again recommends investing 32.5% of your capital in this trade.
Kelly Criterion Portfolio Management and Risk Control
The Kelly Criterion in investing is not just about asset allocation — it requires detailed analysis. It’s essential to know not only what assets are in your portfolio but also how to allocate investments wisely to maximize wealth growth and improve overall market returns.
The most important step is determining the likelihood that each investment will generate a profit. This involves different methods such as technical analysis of price charts, studying company financials (fundamental analysis), and other tools.
In risk management, the Kelly Criterion helps limit losses so you never risk more than you can afford. The formula indicates the maximum amount that can be invested and helps define stop loss levels more accurately. Of course, this doesn’t mean every trade will be profitable. However, when viewed over the long run, this approach increases the probability of steady compound growth.
However, keep in mind: the Kelly Criterion can be quite risky, especially when success seems highly probable. That’s why many traders prefer to use fractional Kelly, reducing their position size for greater safety.
Beyond determining trade size, it’s important to constantly monitor portfolio allocation and adjust it as needed. Markets change continuously, new data emerges, and the probability of success for each trade must be reassessed, along with position size.
Conclusion
The Kelly formula makes sense mathematically, but it is not suitable for everyone. It requires a good understanding of probabilities, accurate estimation of profit and loss percentages, and discipline in applying the calculations. If you misjudge probabilities or overestimate your capabilities, you could lose a significant portion of your capital.
However, when used wisely together with other risk-management and trading psychology techniques, the Kelly Criterion helps optimize trade size and improve long-term performance. Remember, it is only one part of an overall strategy that should be tailored to your needs. Try different variations of the Kelly Criterion, test them on historical data or a LiteFinance demo account, and evaluate your trading results to build your own trading system.
FAQs: Kelly Criterion Explained
The Kelly Criterion helps calculate how much to invest to grow capital over time. The formula shows traders how much of their funds to allocate to each trade, based on the likelihood of success and the potential profit.
Warren Buffett probably does not use the Kelly Criterion, although it was once believed that he and Bill Gross did. This formula focuses on maximizing capital and opening large positions, which can be risky, especially with small capital and market volatility.
The Kelly formula heavily depends on how accurately you estimate the probability of a successful trade. If your estimates are wrong, you risk losing everything. Moreover, the formula is designed for long-term investing and is not suitable for those seeking quick profits.
To reduce risk, traders often use half or even a quarter of the Kelly formula’s suggested amount. This helps avoid large losses while still allowing long-term profit growth. Beginner traders, in particular, should be cautious.
The content of this article reflects the author’s opinion and does not necessarily reflect the official position of LiteFinance broker. The material published on this page is provided for informational purposes only and should not be considered as the provision of investment advice for the purposes of Directive 2014/65/EU.
According to copyright law, this article is considered intellectual property, which includes a prohibition on copying and distributing it without consent.
{{value}} ( {{count}} {{title}} )
This post is originally published on LITEFINANCE.
