Kelly Criterion
The Kelly Criterion is a position-sizing method designed to maximize long-term growth while limiting the chance of losing everything. Instead of guessing how much to invest, the formula uses the probability of success and the expected return to calculate an “optimal” risk amount. It is commonly used in trading, investing, sports betting, and any setting that involves repeated decisions with uncertain outcomes.
The idea is straightforward: if the odds are strongly in your favor, you risk more; if the edge is small, you risk less. The formula avoids betting too much in a single trade, which can lead to large drawdowns, and avoids betting too little, which slows growth. Because the formula assumes accurate probabilities, traders often adjust the output by using a half-Kelly or quarter-Kelly size for safety.
The Kelly Criterion is most effective for strategies that have measurable edges—such as systematic trading, statistical arbitrage, or prediction-market strategies. It provides a disciplined framework for risk management, helping traders avoid emotional decision-making and extreme position sizes.
Why It Matters
The Kelly Criterion helps traders manage risk and grow capital steadily by using a mathematical approach to position sizing. It can improve long-term outcomes and reduce the danger of overexposing a portfolio.
How does the Kelly Criterion work in trading?
The formula uses two inputs: the probability of winning and the ratio of potential gain to potential loss. Traders apply it to estimate what percentage of their capital should be placed in a single trade. If a strategy has a strong statistical edge, Kelly recommends a larger position. If the edge is weak, the percentage becomes smaller. This prevents both under-betting and over-betting.
Why do many traders use half-Kelly instead of the full Kelly amount?
The full Kelly amount maximizes long-term growth in theory, but it can create large swings in practice. Real markets involve uncertainty, inaccurate estimates, and changing conditions. Using half-Kelly or quarter-Kelly reduces volatility and drawdowns while still benefiting from the method’s logic. This approach is more stable and easier to manage emotionally and financially.
When is the Kelly Criterion most useful?
It works best when probabilities are measurable—such as in algorithmic strategies, event-driven trading, prediction markets, or strategies tested through long historical datasets. It is less useful when outcomes are uncertain or purely discretionary. Kelly is particularly helpful for long-term portfolio growth and disciplined risk management.
Real-World Example
A trader has a strategy that wins 60% of the time and produces profits that are twice as large as losses. After applying the Kelly formula, the suggested risk is a specific percentage of capital. The trader uses half-Kelly to reduce volatility and applies this position size consistently across trades.