Kelly Criterion
A formula calculating the theoretically optimal fraction of capital to risk on a bet or trade, given its win probability and payoff ratio.
The Kelly Criterion is a formula, developed by John Kelly Jr., that calculates the theoretically optimal fraction of capital to risk on a given bet or trade, based on its win probability and the ratio between a typical win and a typical loss, in order to maximize the long-run growth rate of capital.
In practice, many traders deliberately risk less than the full Kelly-calculated fraction ("fractional Kelly") specifically because the formula is highly sensitive to inaccurate win-rate or payoff-ratio estimates, and full Kelly sizing can produce uncomfortably large short-term swings even when the underlying edge estimate is correct. See Kaavon's Kelly Criterion calculator for the full formula.
Examples
- Many traders deliberately use "half Kelly" or a similar fraction of the full Kelly-calculated size, trading some long-run growth for meaningfully reduced volatility.
- The Kelly Criterion's optimal fraction is highly sensitive to the accuracy of the win-rate and payoff-ratio inputs, which are themselves estimates, not certainties.