Position Sizing: The Kelly Criterion Explained

The most common reason traders fail isn't bad strategy; it's bad Risk Management. Specifically, betting too big.

The Kelly Criterion is a formula used by gamblers and quants to determine the optimal bet size.

The Formula

$$ f^* = \frac{bp - q}{b} $$

• f*: Fraction of bankroll to wager.
• b: Odds received (e.g., 2 to 1).
• p: Probability of winning.
• q: Probability of losing (1-p).

Real World Example

If you have a strategy with a 60% win rate and a 1:1 risk/reward ratio:

• Kelly says risk 20% of your capital.

The Danger: "Full Kelly"

Betting 20% per trade is volatile. If you hit a losing streak, your drawdown is massive. Most pros use "Half Kelly" or "Quarter Kelly". They take the optimal number and cut it in half safety.

Application

Never risk more than you can afford to lose. Even a strategy with a 99% win rate will eventually hit that 1% loss. If you are "All In," you are out of the game.