What is the Kelly criterion?
In one line: The Kelly criterion is a formula that sizes each bet from your win chance and payoff, aiming for the fastest long-run growth if your numbers are exactly right.
The formula
The Kelly criterion comes from John L. Kelly Jr., a researcher at Bell Labs, in 1956.
Kelly % = W − (1 − W) ÷ R
- W: your chance of winning a trade.
- R: your average win divided by your average loss.
A simple example
Say you win 50% of trades, and the average win is twice the average loss.
Kelly % = 0.50 − (0.50 ÷ 2) = 0.50 − 0.25 = 25%.
Full Kelly says: risk 25% of the account on each trade. Four losses in a row, which happens often at a 50% win rate, would cut the account by about 68%.
Why most traders don't use full Kelly
1. It's very aggressive. Even with the right inputs, full Kelly brings deep drops along the way.
2. It needs accurate inputs, and you don't have them. Your true win rate and payoff are unknown. You only have estimates from past trades.
Watch what a small error does. You estimate a 55% win rate with R = 1.5. Kelly says 0.55 − 0.45 ÷ 1.5 = 25%. But the true win rate is 45%. True Kelly is 0.45 − 0.55 ÷ 1.5 = about 8%. You'd be betting about 3 times too much. Bet well above the true Kelly amount and an account can shrink over time even when the method has an edge.
What traders use instead
- A fraction of Kelly. Half or a quarter of the Kelly number cuts the swings a lot.
- A fixed small percentage. Most traders simply risk a fixed slice, often around 1% a trade. It's easy, and it keeps Risk of ruin low. See how much to risk per trade.
If Kelly gives a big number, read it as "this may have an edge," not "bet this much."
A common mistake
Plugging in numbers from 15 trades. A tiny sample can make the edge look huge, and Kelly turns that into a huge bet. Build a sample of 100+ trades first, and see your likely streaks with the losing streak calculator.
Questions
Is the Kelly criterion good for trading?
It's a useful way to think about sizing. Full Kelly is too aggressive for most people, so traders use a fraction of it or a fixed small risk.
What is half Kelly?
Betting half the Kelly amount. It gives up some growth in theory but makes the swings much smaller and is more forgiving of bad inputs.
What if Kelly gives a negative number?
A negative result means your numbers show no edge. Kelly's answer is to not take that bet at all.
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