The Kelly Criterion is a formula invented by J.L. Kelly Jr in 1956 that determines the optimal risk per trade for a trading strategy or betting system with a positive edge.
1) Win rate: Enter the percentage of trades that your strategy wins
(For example, if you have a 40% win rate, then enter the number "40", not 0.40.)
2) Reward per Dollar Risked: Enter the amount of capital your strategy, on average, profits for every
dollar risked per trade.
(For example: If you strictly following a 2-to-1 reward-to-risk ratio, then enter 2. Despite the advice of
so-called educational services, it's not mathematically necessary for this to be greater than one in order to be
profitable, but the proportion between this and win rate does need to be balanced so that expectancy is positive.
The Kelly Criterion offers the side effect of recommending risking nothing at all, ie. not trading, if expectancy
is negative.)
3) Kelly Fraction: Choose the fraction of the Kelly percentage you want the calculator to output.
(* Using the full Kelly percentage is extremely risky in any real-world financial market as probabilities
are not fixed - market conditions change. Every system or strategy needs room to show its edge is weakening
without wiping out all prior gains.)
In theory, if a system has (and will continue to maintain) a positive expected value (mathematical expectancy), risking the full Kelly criterion percentage on each trade will maximize the return of the strategy. However, traders should always bear in mind that the market is not a static machine but an aggregate of a large number of individual humans (and/or human-designed automated systems) making interacting decisions so conditions do change.
At best, most professional traders recommend using a fraction of the Kelly criterion at the very most.
Either way, both backtesting and past performance are great ways to measure the potential of a strategy or system but also carry a very real limitation: some of the most profitable strategies of the past have, over time, lost their edge due to market changes. Never become over-confident in any particular strategy. Always ensure that any money used to trade is risk capital that you can afford to lose without affecting your standard of living.
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