This method defines
the optimal percent of risk. Relatively to gambling and further,
to stock trading was developed by professor Edward Thorpe.
Kelly's method defines the percent of risk
as
Kelly% = %win – %loss / (Avg_profit / Avg_loss )
Let's look at how the Kelly Criterion might
work. Suppose you have a system that has a winning percentage
60%. Your system also has average profits that are twice as
large as the size of your average loss. Thus, %win = 60%,
%loss = 40% and Avg_profit / Avg_loss = 2. Kelly % = 60 -
40/2 = 40%
Thus, the percentage of equity bet that would provide a maximum
rate of return is 40%.
Number_of_shares = (Kelly% * Current_Capital / starting_risk_per_unity_of_assets)/Security_Price
where starting risk = maximal loss at trade(in %).
Example:
Current Capital - 25000$
Security Price - 50$
Kelly - 0.20 (it's calculated on the basis
of the historical data)
Maximal Loss at trade - 25% (it's calculated on the basis
of the historical data)
In this case you can buy (0.2 * 25000/0.25)/50 = 20000/50
= 400 shares
During his record-breaking trading Larry Williams used the
Kelly's formula where the starting risk was
defined by the size of the margin per futures fontract. Thorpe
recommends using % of risk within 0.5 * Kelly
<= % risk < Kelly bounds.
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