The Kelly Criterion is often used in gambling and investing for money management to ensure zero risk of ruin and maximize growth. It is a formula that also gives insights into trading.
B = ( ( R * W ) – L ) / R, where
- B = Bet size as percentage of porfolio size
- R = Return to risk ratio of trades
- W = Winning percentage of trades
- L = Losing percentage of trades, or 1 – W
The formula implies that it doesn’t make sense to trade unless ( R * W ) – L > 0, or R > ( L / W ). In other words, the return to risk ratio must be greater than the loss to win ratio for a trading system to have an edge.
This suggests that a trading system doesn’t have to give more winning than losing trades in order to have an edge. For example, a trading system that only gives 25% winning trades can still have an edge as long as it can generate a return to risk ratio that is greater than 3.
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