Kelly criterion

The Kelly criterion is a mathematical formula used to calculate the optimal fraction of capital to allocate to a series of trades. It aims to maximize the long-term growth rate of capital. The formula considers the probability of a win (p), the probability of a loss (q), and the average win-to-loss ratio (b) for a given strategy. It dictates the proportion of the current bankroll to risk on each opportunity.

For retail traders, strict application of the Kelly criterion can be too aggressive, often leading to unacceptably large drawdowns and potential ruin. Accurately estimating the win probability and win/loss ratio for a trading strategy is challenging and prone to error. Many traders use a "fractional Kelly" (e.g., 50% of the calculated Kelly fraction) to reduce risk, prioritizing capital preservation over theoretical maximum growth.