Kelly Criterion
Overview
The Kelly Criterion is a mathematical formula for determining the optimal bet size to maximise long-term growth rate. Kelly = (bp - q) / b, where b = odds received, p = probability of winning, q = probability of losing. While theoretically optimal, full Kelly is too aggressive for most traders — half-Kelly or quarter-Kelly is more practical.
Key Concepts
Kelly % = (Win% × Average Win/Average Loss - Loss%) / (Average Win/Average Loss). Full Kelly maximises geometric growth but with extreme variance. Half-Kelly: 75% of full Kelly's growth with significantly less variance. Requires accurate estimation of win rate and payoff ratio. Overestimating edge leads to ruin with Kelly.
Entry Signals
Calculate the Kelly percentage from your historical trade data. Apply half-Kelly for practical use. Example: 55% win rate, 1:1.5 payoff ratio → Kelly = (0.55 × 1.5 - 0.45) / 1.5 = 25%. Half-Kelly = 12.5%.
Exit Signals
If your measured edge (win rate, payoff) decreases, Kelly size decreases. During drawdowns, reduce to quarter-Kelly. Review and recalculate monthly with updated statistics.
Best Timeframes
Applies to overall position sizing strategy, not individual trade management
Pro Tips
Kelly Criterion is theoretically elegant but dangerous with imperfect data. Most traders don't have enough trade history for reliable win rate and payoff ratio estimates. Use Kelly as a ceiling, not a floor.
More Topics in This Category
Maximum Drawdown Limits
A maximum drawdown limit is a predefined loss threshold that triggers mandatory action — reducing size, stopping trading, or reviewing strategy. Common limits: daily max loss (e.g., 3%), weekly max loss (e.g., 5%), monthly max loss (e.g., 10%), and total max drawdown (e.g., 20%). Professional trading firms and prop firms enforce strict drawdown rules.
Fixed-Fractional Position Sizing
Fixed-fractional position sizing risks a fixed percentage of your account on every trade (commonly 1-2%). This ensures that a string of losses reduces position sizes proportionally, protecting capital during drawdowns. It's the most widely recommended position sizing method for discretionary traders because it's simple, sustainable, and mathematically sound.
Risk of Ruin Modeling
Risk of ruin calculates the probability that a trader will lose a specified percentage of their account — typically enough to end their trading career — given their win rate, average reward-to-risk ratio, and percentage risked per trade. This mathematical framework quantifies whether a trading strategy is survivable over the long run and helps traders set appropriate risk limits to ensure longevity.
Trailing Stop Strategies
Trailing stop strategies dynamically adjust your stop-loss level as a trade moves in your favour, locking in progressively more profit while still giving the trade room to develop. Unlike fixed stops, trailing stops adapt to market volatility and price action, allowing traders to capture the majority of a trend move without exiting prematurely on normal pullbacks.