Put simply, the Kelly Criterion or Formula is a way to calculate how much of their assets a Forex trader should risk on any given trade in order to maximize the return.
It became notorious among equities traders because it was said that Warren Buffet uses a version of it when he’s picking his investments. Of course, since there is no such thing as a sure thing in trading, it has its detractors.
Sometimes it’s called the Kelly Strategy, but that can be giving it an undeserved level of usage.
At its core, it’s a calculation of risk relations. It is best suited as a risk and money management tool. It was originally designed for that purpose and became quite popular among gamblers in the middle of the last century.
What Is It?
The formula calculates the percentage of your account that you should invest (K%). That is equal to the historical win percentage (W) of your trading system minus the inverse of the strategy win ratio divided by the personal win/loss ratio (P).
OK, here it is as a formula:
So, let’s say you have a strategy that when applied mathematically, results in a 65% win ratio. That is, applying the strategy, 65 out of 100 trades end up reaching their take profit levels.
But, when you apply the strategy, you are not a machine. You trade in specific hours, you might be slightly distracted, you might not have all the information, etc.
Also, you can use other strategies. You might have a strategy for GBPUSD that’s different from how you invest in gold, for example. Let’s say that you are about average and around 60% of your trades work out. The formula ends up like:
K% = 65% – (1-0.65)/0.60
K% = 7%
In other words, you should invest 7% of your available funds in this scenario in order to maximize the return on your portfolio. (This is a hypothetical case; for forex traders, in practice, it’s usually around 3%).
How is this Useful?
The Kelly Criterion assumes that the purpose of your trade is to maximize your growth of capital, and will reinvest your winnings. That is, put them at risk in the future.
It can then tell you the optimal amount you should invest in each trade, given the strategy and your personal forex trading record.
Of course, for this to work, you have to backtest your FX strategy significantly so you can get as accurate a reading as possible on its success rate.
Same with your own forex trading. You must ensure you have a long trading log with which to accurately assess your winning ratio.