The Kelly criterion is a formula used to derive the optimal size of a bet in a series of bets.In some investing scenarios, with some assumptions the formula will do better than any strategy in the long run.
The Kelly criterion says that amount of bet should be same as the ratio of expectation and gain per unit bet. To illustrate, say there is a 60% chance that an investment goes up by 5% and 40% chance that it goes down by 3%. Then,
The Kelly criterion says that amount of bet should be same as the ratio of expectation and gain per unit bet. To illustrate, say there is a 60% chance that an investment goes up by 5% and 40% chance that it goes down by 3%. Then,
f = Expectation per unit bet / Gain per unit bet
f = (0.6 * 0.05 - 0.4 * 0.03) / 0.05
f = 0.36
That is, we must bet thirty six hundredth of our portfolio to maximize our success. Any bet below is too conservative and any bet above is too aggressive.It is a recommended that the bet actually be only half of the Kelly fraction to avoid incorrect probability and give room for higher losses. Kelly criterion works well only for defined risk trades like vertical spreads, and will not work well for undefined risk trades.
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