“90% of Forex traders do not succeed.”
When one reads “statistics” of this kind the first impression of the Forex market that is formed is one of risk.
Any new trader would think that it is not a safe place to be and so if they decide to participate in it, they need to take risk management measures against it. And they would be right to think all of this.
Risk management is possibly the biggest field of study in trading and investment. Traders are always trying to find the best way to ensure that they are guarding their account against risks that can prove to be fatal.
The Kelly Criterion is a result of this focus on risk management. So let’s take a look at what it is and maybe it will be able to help some traders out there.
What is the Kelly Criterion?
Kelly Criterion is a formula to calculate what amount should be allocated to a trade or investment.
This is what the formula looks like:
K% = W – (1 – W)/P
What does it mean?
So the K clearly stands for Kelly Criterion.
W is the win percentage of your trading system historically.
1 – W denotes the inverse of the win ratio of your trading system.
Finally, P is your personal win loss ratio.
The formula can seem a bit overwhelming but it’s actually quite simple.
So if you apply your strategy to historical data and get a win ratio of 60%; that is your W. This is a measure of how the trading system or strategy works in theory.
When you actually conduct your trades, your winning ratio will be different from what it was in theory because now there are also emotions involved in it and the time and trade that you pick will play a role too. So let’s say your actual winning ratio is 55%.
This means W is 60 and P is 55.
With these numbers, this is what the formula will look like.
K% = 0.65 – (1 – 0.65)/0.55
K% = 2%
Please note that 0.65 is basically 65% win ratio simplified.
This means that you should invest 2% of your account per trade with this winning ratio, according to the Kelly Criterion.
Does it work?
It depends on how well and thoroughly you’ve backtested your strategy. The more you test it the more accurate the winning ratio will be and better the calculation of your risk per trade.
There is no guarantee ever and there will definitely be times when you might end up wishing you had invested a bit more or a bit less. It is, however, a good way to bring some method to the madness that is Forex trading.
This is also one of the reasons why we suggest you record your trades. It gives you real numbers to then use and calculate your risk.
We hope this proved to be somewhat helpful.
As with all trading strategies, the method of application, personal temperament and understanding of the market all have a big role to play in success or failure. The Kelly Criterion is just one way of controlling risk that you can try if you think it might help. We cannot, however, guarantee that it will be optimum for all trades.