How to apply the celebrated bet-sizing and CASH-management formula in trading and wagering.
Gamblers and traders alike should get to know the Kelly criterion intimately.
The formula, developed in 1956 by Bell Labs scientist John Kelly, uses Information Theory to calculate how much to wager or invest to maximize long-term wealth.
But the criterion is often poorly understood, and its misuse leads to the ruin of many would-be traders. Their wealth skyrockets and then collapses to zero because they fail to grasp that the line between defeat and long-term profit is written in the language of mathematics.
Two keys unlock success in professional gambling and serious trading:
Identifying profitable opportunities. Correctly sizing bets. No. 1 is the easy part. No. 2 separates the professionals from the amateurs.
Trend-following “turtle” trader Michael W. Covel put it this way: Trading correctly is 90% money management and portfolio management.
A trader with a mediocre strategy[1] and a great model for risk and bet-sizing will become fairly successful. A trader with a great strategy and a mediocre risk model will go bankrupt.
Examples abound. Think of a blackjack player deciding what percentage of his bankroll to wager on a given hand, a real estate investor who’s determining how much of her portfolio to commit to a new property or a cryptocurrency trader deciding what leverage to apply to a new strategy.
Expected Value
Imagine a betting opportunity that offers positive expected value (EV) with known payouts and probabilities. A blackjack player, for example, knows that the current running count and true count imply a win/loss probability for the next hand of 52% versus 48%.
A 52% chance of winning seems attractive, but how much of the gambler’s total net worth
