Kelly’s Criterion: The Secret Of Trade Management
This little gem will help you improve as a forex trader and have one of the biggest impacts on your risk management. Very important in forex trading for beginners to understand this.
The job hedge fund manager is to manage its’ traders and ensure it’s strategies are followed correctly with optimal trading conditions.
Now, how do you manage their traders?
Simple, introducing Kelly’s Criterion.
This simple calculation essentially rewards performing traders and reduces risk (and capital) from traders currently not performing.
Its math is quite involved with communication and information theory, mostly dealing with probabilities.
Behind the maths, by placing trade position sizes according to Kelly Criterion, you give yourself an edge and can maximize the returns in the long term.
Here is the formula which has been tailored to trading:
K% = W-[(1-W)/R]
Based on your past trading performance, the Kelly Criterion tells you the position sizes you should be taking on your next trade.
Therefore, K% can be expressed as edge/odd. For obvious reason, you don’t want to bet in any game where the expected payout is 0 or negative.
The Inputs to the Kelly Criterion are as follows
W = The winning probability factor / the probability of a trade will be a winning trade
(1-W) = The Losing Probability Factor / the probability that a trade will be losing
R = The Win / Loss Ratio
The Rules
If R remains constant K increases as a traders W increases i.e. The recommendation is to stake larger amounts if a trader is right more of the time
If R remains constant K decreases as a traders W decreases i.e. The recommendation is to stake smaller amounts if a trader is right less of the time
If W remains constant K Increases as a traders W/L Ratio (R) improves i.e. The recommendation is to stake larger amounts as a trader makes more money from each trade.
If W remains constant K decreases as a traders W/L Ratio (R) worsens i.e. The recommendation is to stake smaller amounts as a trader makes less money from each trade.
In the long term, probabilistically – your trading account will have the maximum return possible by using this method.
So it is also common to use a “half Kelly” or half the position size calculated from Kelly Criterion to reduce the portfolio volatility.
The sizing of your transaction is equally important if not more than what you trade.
While most of the trading world talk about what to buy, there is barely any attention to how much you should be trading.
But for every transaction, it always consists of the following elements: what (asset) to buy/sell, when to buy/sell, and how much to buy/sell.
We have gone through some risk management and we hope it has stuck with you as risk management is essentially one of the golden nuggets very little people talk about properly.
Especially Kelly’s Criterion.
However:
Risk management is entirely down to you.
There is no right or wrong way of doing it.
It’s entirely based on your risk tolerance, some of you may prefer 5% risk other maybe 30% risk.
Now we understand what we can do to protect our capital, it is time to learn how we can find trading ideas daily.
Step By Step Guide
Step 1: The Dashboard
As you can see you have the input section to the left and the output selection to the right.
Step 2: Input Section
In this section, we note down EVERY trade we have performed. How much was made and how much was lost then we add a 1 in the Win/Loss Score column.
This will total up our W/R and allows for automatic Kelly’s Criterion computation.
Step 3: The Computation
If done correctly, the formula will work out your Win %, Loss%, Total Win in Money Terms, Total Loss In Money Terms, Win/Loss Ratio, Kelly’s Criterion % Increase or Decrease.
Step 4: Kelly Criterion Output
As you can see, this output suggested that based on the current performance this trader should stake 22.79% of their capital on their next trade to maximise performance.
That is it. Quite simple really with the spreadsheet we’ve provided.
To give you an overview, here is an example based on some test data for the dashboard.
This is key to performing whilst you are at your best and limiting yourself when you are not performing.
Remember
This tool is pivotal in your trading plan. This tool will help you perform at your optimal at all times, winning or losing at forex trading.
We hope from the examples given, you can see the significance of using this tool and its outcomes are there to protect you and your capital.
Don’t be someone in Vegas gambling away and chasing losses.