Kelly Criterion in Forex Trading: What It Is and How It Works

John Kelly was a United States Air Force pilot who fought during World War II. He is not remembered for his feats in the skies, but for his contribution to a cause that is perhaps less important but dear to the hearts of many traders: risk management. He developed a formula (the Kelly formula) capable of providing information about trade volume, a parameter that, precisely, depends on risk. His merit was giving concrete form and value to the concept of risk and transforming it into a resource for money management.

The Kelly Formula

The Kelly formula, from a mathematical point of view, is as follows. W- ((1 - W) /R) Incomprehensible? Probably. Things start to become clear when you give an identity to each factor. W is the probability of winning. This value is obtained by dividing the number of trades (on the asset in question) that were winners by the total number of trades (always on the same asset). R is the ratio between the average win and the average loss. The Kelly formula shows the maximum size for each position by relating the probability of winning, the average win, and the average loss. Obviously, to execute the Kelly formula, it is necessary to have an adequate statistical sample. A sample that belongs to the individual trader. Probability of winning, average win, and average loss, in fact, must be derived from one's own trading history.

A Practical Example of the Kelly Formula

The result of the Kelly formula is a number between, virtually, 0 and 1, which must be converted into a percentage. If the calculation returns, for example, 0.07, this number becomes 7%. It means that, for that particular trade, you should commit a maximum of 7% of your portfolio or trading account. Let's do a practical example. I want to trade on EUR/USD. I go to calculate W. I divide the number of winning positions, let's say 12, by the total number of open positions (in both cases on EUR/USD), let's say 20. W will be equal to 0.6. I now calculate the average of all gains, let's say 400, and the average of all losses, let's say 500. Their ratio, i.e., R, is 0.8. We insert the values into the Kelly formula and solve the equation. The "Kelly" is 10%. This means that you should not commit more than 10% of your capital. Simple, right?