Chapter
The Kelly Formula
Adhering to your stops and exit signals is of paramount importance in becoming
a skillful trader. If for nothing else, even though you can’t make sure of the out-
come of the next trade, you can decide what the maximum loss will be if it turns
out to be a loser by always risking the same relative amount on each trade. The
word relativeis used to indicate that the amount risked should be constant, rela-
tive to the available capital, so that when your account grows, you will risk more
in dollar terms to keep a constant risk per trade in percentage terms.
The amount risked should stay constant because if there is no way of know-
ing the outcome of the next trade, the best we can do is risk the same amount all
the time, on all the trades. To state that another way, if an obvious relationship
existed between the outcomes of all trades, you should vary the bet size based on
whether the next trade would likely be a winner or a loser. However, because we
already know that there is no such relationship between trades for a good system,
the best we can do is risk the same amount all the time.
Also, even if there were such an historical relationship in the past, you are
probably still better off risking the same amount for all trades, as this relationship
may or may not continue to exist in the future. If it doesn’t, you again run the risk
of risking too much at some times and too little at others, which not only will result
in a slower than optimal equity growth but also an increased likelihood of going
broke.
Therefore, much of the balance between skill and luck is captured in how you
determine the size of each trade. One way to enhance your performance in this
area is to use the Kelly formula, which calculates how much capital should be
risked on each trade. However, the Kelly formula is only applicable to strategies
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