Kelly Criterion for Position Sizing

Lesson Content

The Kelly Criterion is a mathematical formula used to determine the optimal size of a series of bets to maximize wealth growth over time. In trading, it helps position sizing by calculating the fraction of capital to allocate to each trade. The formula is f = (bp - q) / b, where 'f' is the fraction of capital to bet, 'b' is the net odds received on the wager, 'p' is the probability of winning, and 'q' is the probability of losing (1-p). For Indian markets, consider a trader analyzing Nifty futures with a 60% win rate and average win-to-loss ratio of 2:1. Here, p=0.6, q=0.4, and b=1 (since 2:1 ratio means for every rupee risked, you gain two rupees). The Kelly fraction would be (1*0.6 - 0.4)/1 = 0.2, suggesting 20% of capital per trade. However, full Kelly can be aggressive; many traders use half-Kelly (10% here) to reduce volatility. When applying to Indian stocks like Reliance or TCS, historical backtesting is crucial as market conditions change. The Kelly Criterion assumes independent trials and known probabilities, which rarely hold perfectly in real markets, making it a guide rather than a strict rule.