Kelly Criterion Formula: What you need to know

We at everytrader.com has set up a Kelly criterion formula calculator for traders to calculate the optimal fraction (F) of their total cash reservoir to invest in stock trading, in order to maximize their return R under a specific trading circumstance. The Kelly formula is very useful, but its application is still limited and actually traders need to know more than just the formula to avoid unnecessarily high risks when using the suggested optimal fraction.

First of all, the probability of winning and losing odds is just a probability which cannot guarantee that a trader would win or lose a particular trade. The reality is that he may lose many trades in a row which could wipe out his account before he actually gains any profitable return. Even experienced traders can lose 5 or 10 or more trades in multiple days in a row. Surely, they may also win multiple trades in a row. The point is, there is uncertainty. This really means that the optimal fraction and optimal return is not for a specific trade. Rather, the optimal return can only be possibly realized after a trader conducted 50 or 100 transactions or more. For this reason, traders need to be cautious and not to bet too much on a particular trade. For instance, if a trader bet 600% of his total cash on a particular trade, he could lose big time!

Second, traders should never buy more than the optimal fraction. Some traders may want to take chances to bet more than the optimal fraction so they may cash in more from a particular trade. Investing more than the optimal fraction will not only not bring in more profit, but actually can subject the traders to a high risk of losing a great deal of cash, which is the point explained above.

Third, even if a trader has a favorable probability (say 60%) to win and a favorable win-to-lose ration (say 0.3 to 0.1), when he uses more than the optimal fraction, he could completely wipe out his account! Many beginner traders are often told by some trainers or coaches that as long as they have a high probability to win and a high win to lose ratio, they cannot lose, which is not true.

View the following graph to understand the point. When p=0.6, q=0.4, b=a=1 (when losing, lose 100%, when winning, win 100%), there is an optimal fraction you can play, which is 20%. When the fraction used to bet exceeds the Kelly optimal fraction, then, you could lose, or even lose 100% of your cash.

Because these and other concerns, it is very hard for beginner traders to invest the optimal fraction because the risk that comes with it is very high. The optimal fraction derived from the Kelly formula does offer a warning that a trader should never invest too much for a trade.