In a previous post Systematic Way of Trading - Stock Board Advice I quoted an advice post on yahoo stock board by a trader. It mentioned a term called “Kelly Criterion” which I never heard of before. I did some research and found this is a term from probability theory. I studied probability theory in my MBA classes before but I didn’t recall this term. I guess MBA classes didn’t cover probability theory that deep. The following is an explanation on Wikipedia.com about Kelly criterion
The Kelly criterion, or Kelly strategy or Kelly formula, or Kelly bet, is a formula used to determine the optimal size of a series of bets. In most gambling scenarios, and some investing scenarios under some simplifying assumptions, the Kelly strategy will do better than any essentially different strategy in the long run.
For simple bets with two outcomes, one involving losing the entire amount bet, and the other involving winning the bet amount multiplied by the payoff odds, the Kelly bet is:
f* = (bp - q)/b.
where
- f* is the fraction of the current bankroll to wager;
- b is the net odds received on the wager (that is, odds are usually quoted as “b to 1″)
- p is the probability of winning;
- q is the probability of losing, which is 1 − p.
As an example, if a gamble has a 60% chance of winning (p = 0.60, q = 0.40), but the gambler receives 1-to-1 odds on a winning bet (b = 1), then the gambler should bet 20% of the bankroll at each opportunity (f* = 0.20), in order to maximize the long-run growth rate of the bankroll. If the gambler has zero edge, i.e. if b = q/p, then the criterion will usually recommend the gambler bets nothing
It might be daunting to understand for someone never get trained on probability theory. I seem to understand it well. I presented similar concept in an early post stock trading vs gambling . But to apply this theory on stock trading a very complex mathematical model is needed to accurately determine the probability of wining and losing. I believe hedge fund and trading firm would hire a troop of Phds to work on mathematical model that calculates the probability. Believe it or not a colleague of mine is recently interviewing with a company doing such research. For general investor like me without using any proprietary software the only way is to take a guess.
Having said that it reminds me a period of time when I didn’t watch the market closely and just set up a limit order to buy or sale. Actually that was before I started this blog. I remember I was able to grow my balance from $30,000 to $40,000 within a month. Maybe a programmed trading is better then manual trading. I found my emotions always take control of my buy and sale decision when I watch the market closely.
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