What is the Kelly Criterion in Trading?

The Kelly Criterion is a mathematical position sizing method. It estimates the proportion of capital to allocate to a trade or investment based on the probability of winning and the expected payoff.

For a simple binary outcome, the following formula is used:

• f* = (bp – q)b

Where:

• f* = Fraction of capital to allocate
• b = Net profit received per unit of capital risked
• p = Probability of winning
• q = Probability of losing, which is calculated as ”1 − p”

Let’s understand Kelly Criterion Position Sizing India through an example. Suppose a strategy has a 60% win probability and a 1:1 payoff ratio: Now, 

• f* = [(1 x 0.60) – 0.40]1 = 0.20

The full Kelly result would therefore be 20% of capital under the assumptions of this example.

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