The Kelly Criterion is a mathematical formula that helps investors and gamblers calculate what percentage of their money they should allocate to each investment or bet.
The Kelly Criterion was created by John Kelly, a researcher at Bell Labs, who originally developed the formula to analyze long-distance telephone signal noise.
The percentage the Kelly equation produces represents the size of a position an investor should take, thereby helping with portfolio diversification and money management.
The winning probability is the ratio of the number of profitable trades to the total number of trades taken. The win/loss ratio is the ratio of the average gain on the trades that ended up in a profit to the average loss on the trades that gave a loss.
Winning Probability = Count of Wins / Count of Total Trades = 6/10 = 0.6
Average gain = Average of ($500, $200, $250, $100, $600, $50) = $283.33
Average loss = Average of ($150, $200, $100, $200) = $162.50
Win/Loss Ration = $283.33/$162.50 = 1.74
Plugging the values in the formula, we get:
Kelly Criterion = 0.37 = 37%
Therefore, you will expose only 37% of your capital in the next trade.
A disadvantage of the Kelly criterion is that it reduces the trade outcomes into just two values positive outcomes and negative outcomes. This also means when applying it, you are not accounting for the volatility of the asset.
The Bottom Line
Money management cannot ensure that you always make spectacular returns, but it can help you limit your losses and maximize your gains through efficient diversification. The Kelly Criterion is one of many models that can be used to help you diversify.