One of our forum members further expands:
The Kelly criterion is a way to optimize your “winnings” in forex. He developed a formula to calculate the percentage of your trading balance that you should risk on each trade.
There are two basic components to the Kelly Criterion:
• Win probability – The probability that any given trade you make will return a positive amount.
• Win/loss ratio – The total positive trade amounts divided by the total negative trade amounts.
These two factors are then put into Kelly’s equation:
Kelly % = W – [(1 – W) / R]
W = Winning probability
R = Win/loss ratio
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The output is the Kelly percentage, which we examine below.
Putting It to Use
Kelly’s system can be put to use by following these simple steps:
Access your last 50-60 trades. You can do this by simply asking your broker, or by checking your recent tax returns (if you claimed all your trades). If you are a more advanced trader with a developed trading system, then you can simply back test the system and take those results. The Kelly Criterion assumes, however, that you trade the same way you traded in the past.
Calculate “W”, the winning probability. To do this, divide the number of trades that returned a positive amount by your total number of trades (positive and negative). This number is better as it gets closer to one. Any number above 0.50 is good.
Calculate “R,” the win/loss ratio. Do this by dividing the average gain of the positive trades by the average loss of the negative trades. You should have a number greater than 1 if your average gains are greater than your average losses. A result less than one is managable as long as the number of losing trades remains small.
Input these numbers into Kelly’s equation: K% = W – [(1 – W) / R].
Record the Kelly % that the equation returns.
Now if we can get the stats for Ash’s trade calls, we can use them to calculate our position size on each trade: