The Successful Trader's Guide to Money Management

CHAPTER 2The Kelly Formula

2.1 Kelly and Co.

In the last chapter I mentioned an ‘optimal’ percentage that should, in winning conditions similar to theoretical conditions, maximize profits if used systematically. This percentage is obtained using a theoretical approach based on the Kelly formula.

Kelly worked at Bell Labs and developed his studies to help the phone company AT&T analyze disturbances in long‐distance calls. The method was first published in 1956: ‘A New Interpretation of Information Rate’. You can find the study online, but I believe only real math buffs will be able to appreciate the subtleties of it. Personally, I just skimmed through it, acutely aware of how little I actually know on this particular subject.

Kelly's study was soon used by professional gamblers to calculate the percentage of the gambler's capital to risk, and maximize profits.

Kelly's criterion considers the distribution of events in the context in which you'll be operating: in consideration of how many times the system is right and how many times it wins on average compared to how many times it loses, it calculates the best percentage to increase your capital.

In practice, Kelly managed to intertwine the statistics of the system, coming up with the best way to exploit them. In his study, he considers the probability of the system winning – in other words, how many times a winning event occurred compared to the total number of events – and then considers how the wins are paid compared to the ...