Definition
The Kelly criterion calculates the fraction of capital that maximizes the logarithmic growth rate of wealth. Full Kelly sizing is theoretically optimal but produces extreme volatility—most practitioners use half-Kelly or quarter-Kelly for smoother returns. The formula requires accurate estimates of win probability and payoff ratio, which are often uncertain.
functions Formula
f* = (bp − q) / b
lightbulb Example
Win probability 55%, payoff ratio 1.5:1 (win $1.50 for every $1 risked). Kelly fraction = (1.5×0.55 − 0.45)/1.5 = 0.25 or 25% of capital. Most traders would use half-Kelly (12.5%) for reduced volatility.
Warning
Full Kelly sizing can lead to extreme drawdowns. Most successful practitioners use fractional Kelly (25-50%).
verified_user Key Points
- Maximizes long-term geometric growth rate
- Full Kelly produces high volatility
- Half or quarter Kelly preferred in practice
- Requires accurate probability and payoff estimates