Definition
Kelly Criterion
The Kelly criterion is a position-sizing formula that determines the fraction of capital to risk on a bet or trade to maximise the long-run growth rate of wealth, given the edge and odds.
For a trading strategy, full-Kelly sizing maximises geometric growth but produces large, stomach-churning drawdowns, so practitioners usually use fractional Kelly, such as half- or quarter-Kelly, to cut volatility. Indian quants apply it to translate a strategy's estimated edge into a sensible bet size.
The formula is powerful but sensitive to inputs: overestimating your edge leads to dangerous over-betting and possible ruin. Because edges in markets are uncertain and time-varying, conservative fractional-Kelly sizing combined with hard risk limits is far more common than mechanically betting the full Kelly fraction.
Related terms
- Quantitative TradingQuantitative trading is an approach that uses mathematical models, statistics and computer algorithms to identify and exploit trading opportunities, replacing discretionary judgement with systematic, data-driven rules.
- Sharpe Ratio OptimisationSharpe ratio optimisation is the process of constructing or tuning a portfolio or strategy to maximise return per unit of risk, measured as excess return divided by volatility.
- Risk ParityRisk parity is a portfolio construction approach that allocates capital so that each asset or asset class contributes equally to total portfolio risk, rather than weighting by capital invested.
- Monte Carlo SimulationMonte Carlo simulation is a technique that runs thousands of randomised scenarios to model the range of possible outcomes for a strategy or portfolio, revealing the distribution of returns, drawdowns and risk.
Plain-English explainer from The Dispatch Investors Encyclopedia. General information, not financial advice.