What Is Kelly Criterion?
The Kelly Criterion is a mathematical formula that calculates the theoretically optimal position size to maximize the long-term growth rate of a portfolio. The formula is: f* = (bp - q) / b, where f* is the fraction of capital to bet, b is the payoff ratio (win/loss), p is the win probability, and q is the loss probability (1 - p).
How Kelly Criterion Works
For example, if your win rate is 55% with a 2:1 reward-to-risk, Kelly says to risk about 32.5% of your capital per trade. In practice, this is far too aggressive — most professional traders use fractional Kelly (half or quarter Kelly) to reduce variance. Full Kelly maximizes growth but creates extreme drawdowns that are psychologically unbearable.
Why It Matters for Traders
Kelly Criterion is valuable as a framework for thinking about position sizing rather than a literal recipe. It proves that overbetting (risking too much) is just as destructive as underbetting. Traders who use Kelly-inspired position sizing — adjusting size based on conviction and edge quality — dramatically outperform those who use fixed sizes for every trade.
