Deriving Trading Basics from the Kelly Criterion

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.

Comparing Trade Quality with R

In the context of my trading system, R measures the initial risk exposure and maximum loss per trade. R is typically 1% of portfolio size in my trading system.

A return of -1R indicates that a trade was closed at the initial stop for maximum loss. A return of 2R means that a trade was closed for a gain of twice the initial risk exposure.

The beauty of using R is that I can directly compare the quality of my trades across different instruments. R is a return to risk ratio. A trade with a return of 3R is better than a trade with a return of 2R in any instrument.

Using Exits and Tactics for Big Positions

I don’t use exits and tactics for most of my own trading. My positions are small relative to the size and liquidity of the markets that I trade. The tight stops that I use are adequate for getting out of winning positions and I don’t have any problems getting my orders filled at a good price.

For positions that are big relative to the size and liquidity of the markets, it’s very important to consider exits and tactics. There’s a good chance that orders would only get partially filled at medicore prices if simple entries, stops, and exits are used.

It may be necessary to break up large orders at various prices to keep others guessing. It’s also a good idea to keep stop orders out of the market to prevent a stop run.

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