How can you use Kelly criterion for effective position sizing? (2024)

FAQs

How can you use Kelly criterion for effective position sizing? ›

For example, if a trade with a 60% chance of winning and a 2:1 payoff ratio, the Kelly criterion suggests betting 20% of the capital for effective position sizing. b = (win amount/loss amount) - 1 In the above example b = 2/1 - 1 = 1 p = 0.6, q = 0.4 K = (0.6*1-0.4)/1 = 0.2, or 20% of capitol.

You use the Kelly Criterion formula (f = [bp – q] / b) to choose bet sizes. In this formula, b is the odds subtracted by 1, p is the probability of winning, q is the probability of losing (1 – p), and f is the bet size.

The Kelly criterion or Kelly strategy is a formula used to determine position sizing to maximize profits while minimizing losses. The method is based on a mathematical formula designed to enhance expected returns while reducing the risk involved.

Understanding Kelly Criterion

The Kelly criterion is currently used by gamblers and investors for risk and money management purposes, to determine what percentage of their bankroll/capital should be used in each bet/trade to maximize long-term growth.

Analysis of the Results

The Kelly criterion results in the K%, which refers to a percentage that represents the size of the portfolio to devote to each investment. Basically, the Kelly percentage provides information on how much one should diversify.

The main advantage of the Kelly criterion, which maximizes the expected value of the logarithm of wealth period by period, is that it maximizes the limiting exponential growth rate of wealth. The main disadvantage of the Kelly criterion is that its suggested wagers may be very large.

Assuming that the expected returns are known, the Kelly criterion leads to higher wealth than any other strategy in the long run (i.e., the theoretical maximum return as the number of bets goes to infinity). John Larry Kelly Jr., a researcher at Bell Labs, described the criterion in 1956.

Optimal f provides the correct optimal fraction to risk in all cases, while the Kelly Criterion only does so in the special case and can result in values greater than 1, which do not represent a true fraction.

What is the Kelly criterion in portfolio management? ›

Kelly Criterion is a formula for sizing bets or investments with a goal of maximizing the expected value of wealth. Unfortunately, this formula is neither commonly taught in university nor discussed in CFA curriculum, making its practical insights a less accessible yet valuable tool for investors.

A positive percentage implies favourable odds.

For example, if your homework assesses the Seahawks' chances as 50/50, or 2.0, rather than the 1.9 on offer then the Kelly Criterion formula is: (0.9 × 0.5 – 0.5) ÷ 0.9 = –5.55.

Applications of the Kelly Criterion

The calculated leverage from Kelly Criterion is the highest point in the chart, which means that betting one cent more than that would increase risk and decrease the growth rate, what is irrational from a bet or investment perspective.

For example, if a trade with a 60% chance of winning and a 2:1 payoff ratio, the Kelly criterion suggests betting 20% of the capital for effective position sizing. b = (win amount/loss amount) - 1 In the above example b = 2/1 - 1 = 1 p = 0.6, q = 0.4 K = (0.6*1-0.4)/1 = 0.2, or 20% of capitol.

In the traditional random walk (or Brownian motion) model, returns for the next time period are random. with some mean μ>0 and some variance σ2>0 σ 2 > 0 . Here the Kelly criterion says that the optimal proportion to choose is roughly p=μ/σ2. p = μ / σ 2 .

Briefly, the Kelly Criterion is a formula designed to tell you how much you should wager on a team. The Martingale is a wagering method based on minimizing loses. Arbitrage Betting involves the opportunistic exploitation of moneylines by wagering on competing teams that are playing one another in the same game.

In probability theory, the Kelly criterion (or Kelly strategy or Kelly bet) is a formula for sizing a bet. The Kelly bet size is found by maximizing the expected value of the logarithm of wealth, which is equivalent to maximizing the expected geometric growth rate.

Kelly Stake Sizing strategy vs Flat staking

This means that if you have a high edge, you can increase the stake; whereas, if you have a low edge, you can reduce the stake. By adapting your stake size in this way, you are able to maximize your profits and minimize your losses over time.

The Kelly criterion (**) says to bet in proportion to what our edge is, not what we think our edge is. So if we think our edge is 10%, meaning our edge is more like 2-3%, then we should bet as if our edge is 2-3%. This translates to betting around 20-25% of the Kelly fraction.