Monday, July 23, 2018

The Kelly Criterion

There is a lot of incorrect information on the web about applying the Kelly criterion in the stockmarket. It is very different to applying it in a card game where you either win or lose a fixed amount. In that context the Kelly criterion tells you how much to bet on each gamble. But whether you are doing short-term trading or long-term investing that is not the case in the financial markets where there are continuous payoffs. In this paper, Ed Thorp lays out the Kelly criterion for investing in financial markets. It results in a rule of how much leverage to use when investing in a portfolio. That portfolio could be a buy and hold portfolio of stocks, or it could be a high turnover futures trading account. To determine how much of total net worth to allocate to a particular asset class or strategy is a different calculation. I think you should maximize the Sharpe ratio for your total portfolio. Where to set the stop loss in trading is a similar calculation - you want to use stop loss rules that maximize the Sharpe ratio for the strategy. I don't think Kelly tells you how much to risk on each trade in the way it can tell you how much to bet on each gamble.

The Kelly criterion isn't a practical rule in the real world as it requires you to continuously change the size of your position as you win or lose money. The suggested leverage for my trading model – this may be exaggerated because of too short a sample of returns and volatility – is greater than that allowed by the futures exchange. This amount of leverage would immediately blow up in the real world and result in huge amounts of commission and bid-ask spread payments...

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