Understanding Kelly Ratio
In my last article we talked about the criteria for developing a good mechanical trading system. The important question is how to develop a trading system, evaluate it and then apply it with real money. There are many factors to consider while testing and evaluating a mechanical trading system.
For each trading system that we test, we need to not only know that the trading system is profitable but also whether it is profitable with limited equity swings. We should know does the trading system have excessive drawdown periods?
Three of the most important elements of mechanical trading systems are: 1) Clear cut rules for entry and exit for each trade. 2) Rules for exiting at profit targets and 3) Rules for exiting at loss targets or how much loss is permissible.
Do losses exceed gains more than what is tolerable in the long run? Does the trading system experience periods of time that result in significant losses that give back those gains when a string of multiple winners and substantial profits accrue?
John Kelly while working at AT&T Bell Labs had developed the formula in 1956 now known by his name. A money management tool used by system traders is the Kelly Formula or Ratio. Most traders do not know when to correctly add on a trading position.
It soon became popular with the gamblers. Gamblers realized its potential as an optimal betting system in horse racing. This formula enabled gamblers to maximize the size of their bets on consecutive races.
Gamblers would use the Kelly Formula to determine how much to parlay winnings into the next bet. Kelly Formula used by many traders to determine how much money to place on the next trade.
Kelly Formula is K=W-[(1-W)/R]. K is the Kelly Ratio percent value. W is the winning probability. It is the probability that any given trade that you make will return a positive amount. R is the Win/Loss Ratio. It is the total positive trade amounts divided by the total negative trade amount.
Kelly Ratio tells you the percent of your total account you should ideally be willing to risk on each trade to maximize your total returns. Suppose K is 25% then you can risk 25% of your account on each trade.
To be on the safe side you should half the ratio. Many traders argue that the Kelly Formula gives too high a figure. Suppose K is 25%. You should half it to 12.5%. It means you should not risk more than 12.5% of your account on a single trade.
You can use it in deciding which trading system is better in the long run. Kelly Formula can help you in comparing two trading systems. You should look for a trading system that has the highest Kelly Ratio.
Back testing is used to evaluate a trading system and show the strength and weaknesses of each trading system. You can use the back testing results in the Kelly Formula.
So back testing combined with the Kelly Formula can help you achieve in most market conditions, the highest trading profits with the lowest risks by choosing a trading system that is the best. - 23208
For each trading system that we test, we need to not only know that the trading system is profitable but also whether it is profitable with limited equity swings. We should know does the trading system have excessive drawdown periods?
Three of the most important elements of mechanical trading systems are: 1) Clear cut rules for entry and exit for each trade. 2) Rules for exiting at profit targets and 3) Rules for exiting at loss targets or how much loss is permissible.
Do losses exceed gains more than what is tolerable in the long run? Does the trading system experience periods of time that result in significant losses that give back those gains when a string of multiple winners and substantial profits accrue?
John Kelly while working at AT&T Bell Labs had developed the formula in 1956 now known by his name. A money management tool used by system traders is the Kelly Formula or Ratio. Most traders do not know when to correctly add on a trading position.
It soon became popular with the gamblers. Gamblers realized its potential as an optimal betting system in horse racing. This formula enabled gamblers to maximize the size of their bets on consecutive races.
Gamblers would use the Kelly Formula to determine how much to parlay winnings into the next bet. Kelly Formula used by many traders to determine how much money to place on the next trade.
Kelly Formula is K=W-[(1-W)/R]. K is the Kelly Ratio percent value. W is the winning probability. It is the probability that any given trade that you make will return a positive amount. R is the Win/Loss Ratio. It is the total positive trade amounts divided by the total negative trade amount.
Kelly Ratio tells you the percent of your total account you should ideally be willing to risk on each trade to maximize your total returns. Suppose K is 25% then you can risk 25% of your account on each trade.
To be on the safe side you should half the ratio. Many traders argue that the Kelly Formula gives too high a figure. Suppose K is 25%. You should half it to 12.5%. It means you should not risk more than 12.5% of your account on a single trade.
You can use it in deciding which trading system is better in the long run. Kelly Formula can help you in comparing two trading systems. You should look for a trading system that has the highest Kelly Ratio.
Back testing is used to evaluate a trading system and show the strength and weaknesses of each trading system. You can use the back testing results in the Kelly Formula.
So back testing combined with the Kelly Formula can help you achieve in most market conditions, the highest trading profits with the lowest risks by choosing a trading system that is the best. - 23208
About the Author:
Mr. Ahmad Hassam has done Masters from Harvard University. He is interested in day trading stocks and forex. Know The Candlestick Patterns. Learn Forex Trading.
posted by X - Men @ 4:07 AM
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