where every winner is the same size and every loser is the same size—hardly the
case in actual trading. Therefore, it should only be used as an approximate value
that should not be exceeded in trading. The Kelly formula looks like this:
K W (1 W) / R
Where:
K Kelly value
W Historical winning percentage
R Historical average win–loss ratio
To begin using the formula, we need to collect some information. Suppose
your five most recent trades ended with a win of 5 percent, a loss of 2, a win of 3,
a win of 1, and a loss of 6, then:
The average value of your winning trades is 3 percent [(5 3 1) / 3].
The average value of your losing trades is 4 percent [(2 6) /2].
The average win–loss ratio is 0.75 (3 / 4).
The likelihood for a winning trade is 0.6 (3 / 5).
The likelihood for a losing trade is 0.4 (1 0.6).
With W equal to 0.6 and R equal to 0.75 (3 / 4), K equals 0.067 [0.6 (1
0.6) / 0.75]. Thus, to make the most of your ability to pick good entry and exit
points, in this particular case no more than 6.7 percent of your trading capital
should be risked on each trade.
Once you know how much of your total equity to risk, you also can calculate
how many shares or contracts to buy to take on that risk and how much of your
available equity you should put toward a particular trade. To do this, you will need
a predetermined stop loss per share or contract. For example, say you’re consider-
ing a stock that currently trades at $50, and its chart shows $46 to be a good stop-
loss point. If you currently have $100,000 of trading capital, here’s how to figure
how much you can trade:
Calculate the amount to risk as the Kelly value times the account size (0.067
* 100,000 $6,700). With a stop loss of 4 points, determine how many shares you
can buy as the amount to risk divided by the stop-loss distance (6,700 / 4 1,675).
Calculate the amount of your capital that needs to go towards this trade as the
stock price times the number of shares to buy (50 * 1,675 $83,759).
The larger K is, the more money you can put into one trade; the smaller K is,
the less money you should put into one trade. Also, the tighter the stop loss, the
more of your capital you need to put into one trade; the wider the stop loss, the
less capital you need to put into one trade. For example, if the stop loss were only
two points away from the entry, then the Kelly formula suggests you should buy
3,350 (6,700 / 3) shares for a total value of $167,500 (3,350 * 50), which you can-290 PART 4 Money Management