Forex traders are a special breed of traders. The gains they make in a week could take a stock trader twice as long to make. They are fast-paced, energetic and quick to spot trends. But one of the things Forex traders have in common with other traders is their continued insistence against using a money management strategy. Many Forex traders use some form of money management but it is far from an exact science. There is, however, a scientifically sound method for the management of money developed from a totally unrelated system created by John Kelly, who worked at AT&T Bell Labs. It is known in some circles as the Kelly Criterion and here we take a look at some of the more interesting applications that it lends itself to.
What Exactly Is the Kelly Criterion?
The Kelly Criterion is a calculation method that was originally developed for use to reduce long distance telephone signal noise issues. Vasily Nekrasov notes,
It maximizes the expected growth rate and the median of the terminal wealth.
What the Kelly Criterion does is to calculate what’s the best return on investment you would have if you were to seek to diversify your portfolio, and at the same time, protect you from massive loss potential on a single trade. Handy idea if you’re looking to close out your Forex trading career as a winner.
How Does It Work?
The Kelly Criterion utilizes two parts of an investor’s portfolio to calculate the optimal percentage of equity one should risk on any particular trade. It uses the following formula to calculate the percentage risk:
Kelly % = W – [(1 – W) / R]
Where W is the winning probability and R is the Win-to-loss Ratio.
Using your last 50-60 trades as a basis for your calculations you can easily calculate the Kelly Percentage of your trades and diversify your portfolio to suit. R is calculated by taking the average positive gain in trade and dividing it by the average loss in negative trade. W can be calculated by, dividing the number of trades that gave a positive return by your number of trades in total (both positive and negative). Investopedia notes,
This number is better as it gets closer to one. Any number above 0.50 is good.
The Kelly Percentage allows you to calculate what percentage of your equity you should be risking per trade. It should be noted, however, that no matter what the K% value says, you should not risk more than 20% of your total equity on a single trade.
Is It Effective?
The effectiveness of the Kelly Criterion depends on how accurate the calculation and application of the data is. Once the trader continues at the current expected rate the Kelly Criterion will work out and the trader will average out a win. However, because trading on the whole is difficult to predict and since losses and market movement can occur irregularly, it is only as effective as the trader that manages to maintain constant success based on the time the Kelly Criterion was calculated for him/her.
Throughout the years, Forex money management strategies have grown and evolved to a point where they are not simply management tools anymore. The Kelly Criterion shows that a money management system can give you a rough estimate of the risk you can be allowed in a trade and work around that risk value. It allows you to diversify your trading options and lock in more trades based on availability. It is, however, still based on your long term performance as a trader and maintaining a certain level of success is the only way to ensure that the Kelly Criterion will work for you.
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