The Kelly Formula
The original Kelly Formula was developed back in 1956 to solve a problem involving random interference on telephone lines. What Kelly discovered was a method of increasing data flow while reducing random information loss.
Before calculating the optimum percent to risk, you need your winning percentage (W%), the average size of your winning trades(W) and the average size of your losing trades(L).
The basic Kelly formula can be calculated as:
Optimum Risk Percent = W% – [(1-W%)/(W/L)]
Let’s have an example. Suppose you have a system that has a winning percentage of 0.6. Your system also has average winning trade of 8 and your average loss is 4. Thus, W% = 0.6 and W = 8 and L = 4.
Using these numbers results in the following:
Optimum Risk Percent = 0.6 – [(1 – 0.6)/(8/4]
= 0.6 – [0.4/2]
=0.6 – 0.2
=0.4
Thus, the percentage of equity that would provide a maximum rate of return is 40%.
The major problem with the Kelly formula is drawdown. If you have a system that is right 60% of the time, you could still be wrong 10 or even 15 times in a row sometime during your lifetime of trading. Risking too high a percentage would be disastrous. The Kelly formula implies (sorry, you have to read the original report) that unless your drawdown is less than 25%, never risk more than 25% of you equity.
The Kelly Formula is critical for traders wanting optimal rates of return. For practical application of the Kelly Formula, use 80% of the Kelly %. In the above example – we derived an optimum risk size of 40% of capital. This is too high for practical use. Instead, we would use 80% of 25% which is equal to 20%. Determine how many trades you are likely to have on at one time and then divide your 80%-Kelly value by that number of trades. For example, if you are likely to have as many as 8 trades at one time, then your optimal trading size, using the above example, would be [20%/8] or about 2.5% of your trading equity.
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