Using the Kelly Criterion to Manage Risk

[RichardCox 10]

The Kelly Criterion is generally viewed by stock investors as a way of achieving diversification in a portfolio. But the principle can be applied to forex markets as well, since the essential themes relate to money management and the levels of investment that should be placed in each trade. Since money management systems can also give traders an idea of when to buy or sell a trade, we can look at the Kelly Criterion as a technique for giving traders strategies for more effective money management.

 

Foundations of the System

 

Initially, John Kelly developed the Kelly Criterion for AT&T as a way of handling noise problems in long distance telephone calls, originally calling his theory "A New Interpretation Of Information Rate." But as we will see, the theory has a wide variety of applications and the horse racing gambling community was the first to seize on these advantages and to optimize betting systems to increase returns over the longer term. In its most modern applications, investors have begun to use the system as a money management strategy to achieve the same results.

 

Basic Components of the Kelly Criterion

 

The Kelly Criterion has two essential components:

 

Maximizing Win Probabilities – Increasing the chances that individual trades will create positive returns

 

Improving Win to Loss Ratios – Improving the positive amounts relative to negative trade amounts

 

These elements then become part of Kelly's general equation (the Kelly Percentage), which is:

 

The Kelly Percentage = Winning Probability – [(1 – Winning Probability) / Win to Loss Ratio]

 

Applying the Kelly System to Your Trades

 

The Kelly system can be applied to your trading by first looking at your previous 50 trades. This can be done by looking at your account's trading history or using back-testing applications. But it should be noted that the Kelly Criterion assumes that future trading activity will mirror your previous trading activity.

 

Next, we calculate the Winning Probability, which is done by dividing the number of positive trades by the total number of trades. Numbers above 0.5 are acceptable while 1 is ideal.

 

Next, we calculate the Win to Loss Ratio, which is done by dividing the average gain in your positive trades by the average losses in your negative trades. If you average gain is greater than your average loss, this number will be greater than 1. Numbers lower than once can still be acceptable, however, if the total number of losing trades is minor.

 

Next, these numbers are put into the Kelly Equation and the total percentage will give you your key figure. The percentage will tell you the position size that should be used in your trades. For example, a Kelly percentage of 0.03 suggests that each trade should be equal to 3% of your total trading activity. Excessively high percentages, however, should be disregarded (anything above 20%), as this places too much risk in one trade.

 

Conclusion

 

While it is true that there are no ideal or perfect money management systems, the Kelly Criterion can still help traders to manage trades in a more efficient way. Of course, the system has limitations, as the Kelly Criterion cannot tell you which trades to take and the system can falter if traders begin to trade inconsistently (or in the case of significant market crashes). The Kelly Criterion can, however, help to manage those surprises by increasing overall efficiency.

 

Random changes in volatility and market conditions will become a key variable to watch, as these things will have an impact on your total returns even when the Kelly Criterion is implemented. Temporary fluctuations in account values are unavoidable but over the long term, your main goal should be to achieve higher levels of consistency and efficiency. While money management alone will not ensure enormous trading gains, it can help you to maximize your returns by limiting your losses as your trades are appropriately diversified. The Kelly Criterion is one method for helping to create this type of diversification in your trading account.