Risk Management Chapter 4
The Kelly Criterion
Let's explore the Kelly Criterion and how it applies to managing risk while trading. The Kelly Criterion is a powerful tool that can help traders determine the optimal size of their positions based on considerations of risk and return.
Maximizing Returns with Risk Management
What Is the Kelly Criterion?
The Kelly Criterion is a mathematical formula that guides traders in the determination of the ideal amount of capital to be allocated to a particular trade opportunity. The Kelly Criterion seeks to maximize long-term growth while minimizing the likelihood of significant losses by balancing potential returns and associated risks.
Origins and History
John Kelly, a researcher at Bell Labs, created the Kelly Criterion to address long-distance telephone signal noise issues.
The method was published in 1956 as “A New Interpretation of Information Rate.”
The gambling community later recognized its potential as an optimal betting system, especially in horse racing.
Over time, the Kelly Criterion gained popularity among investors, including Warren Buffet, Charlie Munger, and Bill Gross.
Key Components of the Kelly Criterion
Winning Probability (W):
Represents the odds that any given trade will return a positive amount.
Calculated based on historical data or statistical analysis.
Win/Loss Ratio:
Measures the total positive trade amounts divided by the total negative trade amounts.
Reflects the risk-to-reward ratio.
Kelly’s Formula:
Kelly percentage number – the percentage of your trading account balance you are allowed to risk on any one trade
W = Win Rate probability
R = Win/Loss Ratio or R multiple
Application of the Kelly criterion in trading
Here is a simple example of the application of the Kelly criterion in trading scenarios.
Suppose you've evaluated your trading strategy over 100 trades. You've had 30 wins and 70 losses. On average, the strategy has returned $3 in profit for every dollar of risk.
To determine the winning rate, divide the number of successful trades by the total number of trades made. The result of this calculation is the win rate (W)
The Win/Loss Ratio is simplified as follows: The system's average return is $3 for every $1 at risk:
According to the Kelly Criterion, 6.67% is the optimal portion of your account to risk per trade for maximal growth. For instance, with a $10,000 account, you could allocate $670 per trade.
Understanding the Kelly Criterion
Especially for short-term trading strategies, the Kelly Criterion is a guide, not a rule. It's more appropriate for long-term trading, where it can be an aid to risk allocation across assets or portfolios.
Even with a Kelly percentage of 6.67%, blind adherence to it can be disastrous, especially when trading on a short-term basis. Discretion is essential to avoid getting burned out fast.
The limitations of the Kelly criterion
No mathematical model is flawless, and the Kelly Criteria is no exception. In a volatile market, the Kelly Criterion assumes consistent win rates and win/loss ratios, which is unrealistic.
Therefore, always consider your maximum risk tolerance when using the Kelly Criterion as one of several risk management tools.
Adjustment of the risk using the Kelly criterion
Your risk tolerance is individual. When determining your maximum risk level, consider the impact of potential losses on your trading psychology and equity. If you're a risk-averse, you may choose to take less risk per trade to protect your capital. You may accept smaller profits. Conversely, if you're a risk-taker, you may want to accept higher risks for greater potential rewards, knowing that losses could be substantial.
Refinement of Kelly percentage
In order to get a more accurate Kelly percentage, you should base your calculations on a larger number of historical trades. While there's no hard and fast rule for the ideal number, it's recommended that you analyze at least 100 similar trades in a given market.
Benefits and Considerations
Maximized Growth: The goal of the Kelly criterion is long-term capital growth.
Risk Control: It helps manage risk by adjusting position sizes.
Not Foolproof: Please note that market conditions and assumptions may affect the actual results.
Adaptability: Traders can apply the Kelly Criterion to a variety of different instruments (futures).
To summarize, the Kelly Criterion provides a systematic approach to managing risk that allows traders and investors to optimize position sizing and improve overall performance.
Remember to consider how much risk you want to take, and tailor the strategy to suit you.