Question on Kelly Formula : Positive Expectancy But...

[Question on Kelly Formula : Positive Expectancy But...]

As Mammy Yokum said: "Truer words were never spoke."

The larger your trade size and the higher the account value, the more likely you are to sabotage your system.

 

 

The problem with using the Kelly formula, or any other formula that considers closed trades is that there is no consideration of what happens DURING the trade - in other words, the drawdown that can and does occur while waiting for the system to close out of the position.

 

Not only is there the drawdown that happens during one trade, but there is the accumulated drawdown from a series of trades. Even if your system produced 100% profitable trades on a closed trade basis, if the intra-trade drawdown is large, it is going to cause you much grief and it is likely you will bail on your trade and system well before your system pulls you out.

 

I use TradeStation to backtest my systems, and always look at the Strategy Performance Report. Then I look at the Max Drawdown Intra-day Peak to Valley calculation.

 

I then allocate 10x this number to trade 1 futures contract. This way, when this drawdown occurs again (and it WILL) I will only be down 10% in my account equity - a number I have found I can handle without getting extremely upset. If your account is small, you might be able to handle up to 30% drawdown before you panic, but as your account size increases, it becomes increasingly more difficult to take drawdown of this magnitude.

 

If you get extremely upset, and everyone has a different point where this occurs - but it does and will occur, you will 1) exit your trade at the wrong time, 2) be unable to sleep, 3) stop trading your system, or 4) some other irrational behavior. Have you ever just said, "I can't take this anymore", and just sold everything?

 

If you are overleveraged and trading futures, you may just run out of equity and get a margin call - and that's the end of your trading either permanently or temporarily.

 

The trouble with a system that shows a 2:1 profit factor, that is, winning trades make double the losing trades, but you have fewer than 50% winning trades, is that you have a lot of losing trades - tough to handle emotionally. Also, the winning trades come from a subset of the whole universe of closed trades, and this might mean that the winners were based on some unusual price behavior not llikely to occur in the future.

 

The ideal system has maximum gains and minimum drawdown, and ideally, seldom has a losing day.

 

The simplest example of a system that is almost impossible to trade, yet looks great on paper (compute the Kelly formula) , is a buy and hold. It may have 1 profitable trade,and no losing trades. However, the intra-day drawdown peak to valley might be HUGE. That's what will bury you as a trader.

[Increasing Your Position Size Over Time]

No, this is the one I teach my students. It comes with the territory.

 

If that's the Ultimate-F that you charge $6500 for then this post is probably against the terms of this site.

[Question on Kelly Formula : Positive Expectancy But...]

I have a chart of the results ... I can't reveal the calculations, as, unlike Vince, mine is proprietary and I offer it to my students without revealing the code. My code uses the actual trade values and calculates the number of shares to put on for the next trade. To use the code you must have a minimum of 30 actual trades to put into the spreadhseet.

Sunny

 

I can see a few problems with optimal-f from just a quick look at it though. It is guilty of the same problem that problem that the Kelly criterion is, i.e. not looking at the instances around the mean, only at the estimated values. Does the modified version fix this?? Do you have any links describing its calculation?

 

As far as I can tell it is only useful for ball parking and quick, on the spot math.

 

I looked at this for information on calculating the original "optimal" f.

Contango: Optimal f

 

Thank you.

Silentdud

[Question on Kelly Formula : Positive Expectancy But...]

I have a modified Ralph Vince optimal-f that I call Ultimate-F, because it avoids the high risk of ruin. It is much better than the Kelly formula and still compounds your results dramatically. YES, it works great with 45% or even 40% as long as your CPC Index is greater than 1.2.

 

 

Hello everyone,

 

I am currently reading about the Kelly formula on various website.

I now understand better that money management is a powerful tool to use when trading.

 

However something escapes me:

Assuming one has a trading system tat delivers a positive expectancy BUT there are fewer winning trades than losing trades, how to use the kelly formula??

 

e.g:

 

winning trades : 45%

losing trades : 55%

 

average win: 2,000

average loss: 1,000

 

expectancy is positive with : 0.45 * 2,000 - 0.55 * 1,000 = 350

 

Yet the K% would be negative because there are only 45% winning trades.

 

K% = (0.45 - 0.55) / 2 (where 2 is derived from 2,000 / 1,000)

 

Is there a more "refined/updated" Kelly formula that addresses this issue or this kind of bet should be considered a bad trade and should be avoided ?

 

Thanks!

[TradeStation Made Easy!]

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