Kelly Ratio Explained
In one of my articles, I talked about the criteria for developing a good mechanical trading system. There are many factors to consider while testing and evaluating a mechanical trading system. The important question is how to develop a trading system, evaluate it and then apply it with real money.
We need to not only know that the trading system is profitable for each trading system that we test. But we should also know whether it is profitable with limited equity swings. We should know does the trading system have excessive drawdown periods?
Three of the most important elements of mechanical trading systems are: 1) Clear cut rules for entry and exit for each trade. 2) Rules for exiting at profit targets and 3) Rules for exiting at loss targets or how much loss is permissible.
Do losses exceed gains more than what is tolerable in the long run? Does the trading system experience periods of time that result in significant losses that give back those gains when a string of multiple winners and substantial profits accrue?
Most traders do not know when to correctly add on a trading position. A money management tool used by system traders is the Kelly Formula or Ratio. John Kelly while working at AT&T Bell Labs had developed the formula in 1956.
It soon became popular with the gamblers. Gamblers realized its potential as an optimal betting system in horse racing. This formula enabled gamblers to maximize the size of their bets on consecutive races.
It was used to determine how much to parlay winnings into the next bet. The system is used by many traders to determine how much money to place on the next trade.
Kelly Ratio is given by the formula: K=W-[(1-W)/R] where K is the Kelly Ratio in percentage. W is the winning probability and it is the probability that any given trade that you make will return a positive amount. R is the Win/Loss Ratio and it is the total positive trade amounts divided by the total negative trade amount.
Suppose K is 25% then you can risk 25% of your account on each trade. Kelly Ratio tells you what you should ideally be willing to risk on each trade to maximize your total returns in terms of the percent of your total account.
To be on the safe side you should half the ratio. Suppose K is 25%. You should half it to 12.5%. What it means is that you should not risk more than 12.5% of your account on a single trade. Many traders argue that the Kelly Formula gives too high a figure so half it to be on the safe side.
Kelly Formula can help you in comparing two trading systems. You can use it in deciding which one is better in the long run. You should look for a trading system that has the highest Kelly Ratio.
Back testing is used to evaluate a trading system and show the strength and weaknesses of each trading system. You can use the back testing results in the Kelly Formula.
So back testing combined with the Kelly Formula can help you achieve the highest trading profits with the lowest risks in most market conditions.