Why Kelly Ratio is Important in Trading?

You have a limited amount of money for trading whether it is $1,000 or $1,000,000, once it’s gone, you are done with trading. The problem is that you can have a long string of losing trades before you hit a winner with your trading system.

The riskier you’re trading strategy, the more thought you need to give to your money management style. Otherwise, you can find yourself out of the market with a margin call in no time. Let’s say, you trade 100% of your account. You only need one losing trade to lose 100% of your account. Suppose, you divide your trading account into 10 equal parts. Now, you can have 10 losers before you are out of the market.

You want to reduce risk further in your trading. You divide the capital in the trading account into 100 equal parts. Now, you only risk 1/100 of the capital in the trading account on a single trade. Suppose you lose. You only lose 1/100 of the capital. Suppose, you lose 100 times in a row. You are done. But the chances of making 100 losing trades in a row statistically speaking are very very low. So, you are on a more safe ground. This is the essence of risk management. You only risk what you can afford to lose. Experienced traders divide the capital in their account into 50 equal parts and they risk only 1/50 of the capital on a single trade. In other words, they don’t risk more than 2% on each trade. This should give you the idea. Trading is all about long term survival. You lose in the start but eventually you start hitting winners consistently. This grows the capital in your trading account into a large sum by compouding the wins overtime.

But there is always a trade off. Remember the most important rule in finance, “no risk, no return.” In other words, the more return you want, the more risk you will have to take. But how much you should risk to get a decent reward? This is the most important thing for you. You don’t want to risk everything of course. So you don’t want to risk everything on a single trade as long as there is some risk of losing your money. But at the same time you want a decent return to make in your trading otherwise there is no purpose of trading. So, how to go about it.

So what you need is a good money management system that tells you the position size for each trade that you should bet. Kelly Criterion emerged from the work done on signal noise issues in 1950s in the famous Bell Labs. Very soon, the mathematicians who had developed this formula saw its’ application in gambling and trading and in no time this formula took off with the traders.

In order to calculate the percentage of your trading account to put at risk, you need to know the percentage of your expected winning trades, ratio of winning trades to the losing trades as well as the return from the winning trades. These ratios are unique to each trading system. Once you have them, you can calculate the percentage of your trading account that you can risk with that trading system; Kelly %age=W-{(1-W)/R}.

W is the percentage of winning trades that the system makes over time. R is the average gain of the winning trade over the average loss of the losing trade. Many traders divide this percentage by 2 to be on a more safe side.

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