Hi Mikhail,
Best of luck with your 100 trade experiment - keep the discipline
Kind Regards
Steve
Indeed, this is of utmost importance. Kelly's formula provides you with the optimal percent of your capital you can risk on a single trade. To use the formula, you have to know the history of a trading system performance: what is the size of a win W (or average win size if it varies), what is the size of a loss L (or its average) and the proportion P of wins out of total number of bets. The assumption is that you place one bet (trade) at a time. Kelly's percent is calculated then using this simple formula:
Kelly% = P - [(1-P)/(W/L]
For example, take Pouria's trades for Jan-Feb 2006 (I'm just starting optimizing this method...). If you'd use a 46 p. SL and a 33 p. TP target (spread not taken into account), you'd have 5 losses and 33 wins (P = .87). So, Kelly% is
Kelly% = .87 - [(1-.87)/(33/46)] = .69.
This means, that you can risk 69% of your capital on a single trade. If you have a 1000 p. capital, and you can risk 690 p., you can you can open 690/46 = 15 positions (again, spread and margin considerations nottaken into account).
Since Kelly% is based on historical performance, and history never repeats itself (at least, the better parts of history, the worst ones tend to repeat over and over again), and since using exact Kelly% leads to huge drawdowns, and since most people don't have the nerve for such a risk, it's customary to use half the Kelly's percent, i.e., in our example, open 7 positions. I don't even have the nerve for that, and usually don't risk more than 15% simulteneously...
mwilkinw, please correct me if I got something wrong. I teach statistics, but always have all my calculus messed up...
Hey Ilanr! Thanks for doing some of the clarifying for me! The Kelly formula is a great formula for traders
That formula is correct. The kelly formula allows you to figure out your position size based on past performace. (that is why I like backtesting so much)... Having your total profit percentage, your average win, and your average loss will allow you to formulate how large your trade or (bet size) will be as a percentage of your equity.
This is a great way to increase your profits, because as your equity grows your bet sizes grow. This allows you to add to your winning trades and minimize your losses with a set SL.
Figuring out where to take your profit and where your SL is... and backtesting to receive your Profit%, Average Win, Average Loss Data... based on your historical performance, gives you a much better system of increasing your profits and managing your downside without burning out your account.
However, as was stated for securities trading I suggest a 'half kelly" system. I use 80% of the kelly... 80% of the kelly figure is practical and will optimize your rate of return. Determine how many trades you are likely to have on at one time and then divide your 80%-Kelly value by that number of trades.
Increasing your position by the Kelly-Value determined by your increased equity will exponentially grow the size of your winners and keep your losers at a steady loss as determined by your SL.
If you use a strict money management system and know your profitibility, average wins and average losses.. theoretically you will be profitable.
This system was made famous by Dr. Edward Thorp and is used to beat the dealer in blackjack... this is how he broke Vegas and eventually made billions with his hedge fund from the 60's to the 80's.
Optimum Risk Percent = W% - [(1-W%)/(W/L)]
(W%) is your winning percentage, (W) is the average size of your winning trades, (L) is the average size of your losing trades
This is a critical system for traders who want optimal rates of return. For practical application, use the 80%-Kelly Value for your trading.
Plug in your data and solve left to right.
Happy Trading!
P.S. Ilanr.. you're a statistician... I'm a mathematician!
