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Abstract
It is a formula for calculating how much to bet
handicapper = manager for handicap
Kelly Formula
What is the Kelly criterion (or formula)? It is a formula for calculating how much to bet. It assumes that
your objective is long term capital growth (getting rich). The handicapper's choice of money management
strategy is similar to the stock market choice between growth stocks and income stocks. Growth stocks tend to
be more volatile, but in the long term return more profit. That is because the profits from growth stocks are
reinvested rather than skimmed off. Every reinvestment is a calculated risk. Therefore, income stocks tend to
fluctuate in value less, but also return less profit in the long term. Kelly betting is for growth. It
reinvests profits, and thus puts them at risk. If your objective is to make small but consistent profits, it
may be too aggressive a money management scheme.
Kelly's seminal paper, A New Interpretation of Information Rate, 1956, examines ways to send data over
telephone lines. One part of his work, The Kelly Formula, also applies to trading, to optimize bet size.
In reality, I think Kelly's formula is too risky for real money management. One reason is, your trading size
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Number_of_shares = (Kelly% * Current_Capital / starting_risk_per_unity_of_assets)/Security_Price
Example:
Maximal Loss at trade - 25% (it's calculated on the basis of the historical data)
In this case you can buy (0.2 * 25000/0.25)/50 = 20000/50 = 400 shares
During his record-breaking trading Larry Williams used the Kelly's formula where the starting risk was defined
by the size of the margin per futures fontract. Thorpe recommends using % of risk within 0.5 * Kelly <= % risk
< Kelly bounds.
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