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Understanding the Kelly Criterion


Kelly Criterion is a formula that can help traders and investors determine the optimal position size for a given trade, based on their trading edge and risk tolerance. It was developed by John L. Kelly Jr. in the 1950s, and has been used by traders and investors ever since. In this blog post, we will discuss how the Kelly % is calculated and how it can be used in day trading and investing.


The Kelly % Formula


The Kelly % formula is relatively simple, but it requires some input data to be accurate. Here is the formula:


Kelly % = (W – (1 – W)) / R


Where:


W = Winning probability

R = Win/Loss ratio

Let’s break down each component of the formula:


Winning Probability (W): This is the probability of your trade being profitable. It can be calculated by analyzing historical data, technical indicators, or fundamental analysis. In other words, it’s the percentage of time you expect to make money on a particular trade.


Win/Loss Ratio (R): This is the ratio of the average win to the average loss. For example, if your average win is $200 and your average loss is $100, then your win/loss ratio would be 2:1. You can calculate this ratio by analyzing historical data, or by tracking your trades over time.


Once you have calculated W and R, you can use the formula to determine the Kelly %, which represents the percentage of your trading account that you should risk on a particular trade.


How to Use the Kelly % in Day Trading and Investing


The Kelly % can be a useful tool for day traders and investors to determine their position size. However, it’s important to note that it’s not a one-size-fits-all solution, and traders and investors should always consider their own risk tolerance and trading goals.


Here are the steps to use the Kelly % in day trading and investing:


Step 1: Calculate your winning probability (W) and win/loss ratio (R) for a particular trade.


Step 2: Plug in the values of W and R into the Kelly % formula.


Step 3: Determine the position size that corresponds to the Kelly %, based on the total capital in your trading account.


For example, if your winning probability is 60% and your win/loss ratio is 2:1, your Kelly % would be:


Kelly % = (0.6 - 0.4) / 2

Kelly % = 0.1


Assuming you have $10,000 in your trading account, your position size would be 10% of your account balance:


Position size = Kelly % * Account balance

Position size = 0.1 * $10,000

Position size = $1,000


This means you should risk $1,000 on this trade, based on the Kelly % formula.


Conclusion


The Kelly % is a useful formula for day traders and investors to determine their position size, based on their trading edge and risk tolerance. However, it’s important to note that the Kelly % is not a guarantee of success, and traders and investors should always consider their own trading goals and risk management strategies. By using the Kelly % formula in combination with other trading tools and strategies, traders and investors can make more informed trading decisions and manage their risk more effectively.


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