KELLY CRITERION | Ed Thorp | Optimal Position Sizing For Stock Trading

Summary

This video reviews the Kelly Criterion, a strategy for optimizing position sizes in trading and investing, developed by John Kelly and popularized by Edward Thorpe. It explains how to calculate the optimal stake based on equity balance, expected return, and probabilities of winning and losing. The presenter uses examples from both sports betting and personal trading statistics to illustrate the application of the Kelly Criterion, emphasizing the importance of adjusting position sizes according to performance. The concept of fractional Kelly is introduced to mitigate risk, making it a practical tool for managing capital in dynamic markets.

Takeaways

• 😀 The Kelly Criterion, developed by John Kelly in 1956, helps determine optimal stake sizes for trading and betting based on various factors.
• 📈 It considers four main variables: equity balance, expected return, probability of winning, and probability of losing.
• 🧮 The formula calculates the perceived edge in an event, adjusting the stake size accordingly to maximize growth.
• 🥊 In sports betting, the analysis of competitors’ advantages can lead to more accurate probability assessments than market odds.
• 💰 For example, using a betting bank of $1,000, a 55% win probability yields an optimal stake of $50 based on the Kelly Criterion.
• 📊 The author's personal trading stats demonstrate a 59% win rate and a recommended position size of $9,800 from a $20,000 equity balance.
• 🔍 Many traders, including the author, prefer fractional Kelly to manage risk, using only a fraction (like 33%) of the calculated position size.
• ⚖️ Applying fractional Kelly reduces potential exposure, especially in volatile markets, allowing for a calculated risk management approach.
• 📉 The randomness of the stock market complicates the application of the Kelly Criterion, making regular performance tracking essential.
• 📅 The author suggests that a trending market can enhance the edge, leading to increased position sizes, while a ranging market may require reductions.

Q & A

What is the Kelly Criterion?

The Kelly Criterion is a formula used to determine the optimal stake or position size for betting or investing, based on the balance of equity, expected returns, and the probabilities of winning and losing.

Who originally developed the Kelly Criterion?

The Kelly Criterion was created by John Kelly, a computer scientist, in a paper published in 1956. It was later popularized by Edward Thorp, who applied it to improve strategies in blackjack.

How does the Kelly Criterion calculate the optimum stake?

The Kelly Criterion calculates the optimum stake by considering four factors: equity balance, expected return from a winning outcome, probability of winning, and probability of losing, ultimately determining the perceived edge over an event.

What is an example of applying the Kelly Criterion in sports betting?

In a boxing match scenario, if boxer B has a 55% chance of winning based on analysis, the Kelly Criterion can be applied to determine an optimal stake based on the expected return and perceived edge.

What is the significance of fractional Kelly?

Fractional Kelly involves using a fraction (like 33%) of the recommended position size to manage risk more conservatively, reducing potential volatility while still allowing for capital allocation based on the calculated edge.

How do you determine the expected return in trading?

Expected return in trading can be calculated by analyzing the anticipated profit for each winning trade relative to the amount risked. For example, an expected profit of $4.04 for every $1 risked indicates a high potential return.

Why is it challenging to apply the Kelly Criterion to stock markets?

Applying the Kelly Criterion to stock markets is challenging due to the randomness and variability of price movements influenced by numerous unpredictable factors, unlike fixed outcomes in games like blackjack.

What should traders do if their performance metrics change?

Traders should continuously track their performance and adjust the inputs for the Kelly Criterion accordingly, as changing win rates or profit margins can significantly impact optimal position sizes.

What does the graph illustrating the Kelly Criterion represent?

The graph represents the relationship between full Kelly and fractional Kelly, indicating that higher stakes typically lead to greater volatility and less predictable returns, while smaller stakes provide more stable but lower returns.

What is the recommended risk based on a typical stop loss in the example provided?

In the example, a typical stop loss of around 10% of the position size results in a risk of approximately $326 on a position size of $3,266, equating to a risk on equity of 1.63%.