Kelly Criterion and Currency Pair Trading
The Kelly criterion is a formula for sizing a bet or investment, aiming to maximize the expected geometric growth rate of wealth. It was developed by J. L. Kelly Jr., a researcher at Bell Labs, in 1956. In currency pair trading, the Kelly criterion can be applied to determine the optimal position size based on the trader’s past performance and the probability of a positive outcome.
Currency pair trading is the simultaneous buying of one currency and selling of another in the foreign exchange market. Currencies are traded against one another in pairs, with each currency pair constituting an individual trading product. The most traded currency pairs are known as the “majors” and include EUR/USD, USD/JPY, GBP/USD, and USD/CHF.
To apply the Kelly criterion in currency pair trading, you need to calculate the probability of a positive outcome (winning trade) and the total win-loss ratio, which is the total number of winning trades divided by the total number of losing trades. These two factors are then input into the Kelly criterion equation to derive the optimal trade size in relation to the probability of the trade being positive.
It’s important to note that the Kelly criterion is valid only for known outcome probabilities, which is not the case with investments. Risk-averse investors should not invest the full Kelly fraction. Moreover, the Kelly criterion is an advanced money management tool and should be used with caution, especially by beginner traders. When using the Kelly criterion in currency pair trading, it’s essential to consider the market conditions and only include similar trades in the calculation. For example, if prices are currently trending and you want to determine how much you can afford to risk on a new position, only include those similar trades that were also taken during trending conditions in the Kelly criterion calculation. This will help to keep your risk management strategy consistent with the current market environment.
A example Calculation using Excel:
- Given Values
– Win Percentage (Probability of being right): 32%
– Loss Percentage (Probability of being wrong): 68%
– Bankroll (BR): $10,000.00
– Percent of Bankroll Used per Trade: 0.01 (1%)
– Risk Reward Ratio: 2.5 to 1 (If the trade is successful, the profit is 2.5 times the loss)
– Expected Return When Right: $250 (Profit if right) * 32% = $80.00
– Expected Return When Wrong: -$100 (Loss if wrong) * 68% = -$68.00
– Average Expected Return per Trade: $80.00 + (-$68.00) = $12.00
- Expectation Over Many Trades:
– If you consistently apply a risk-reward ratio of 2.5 to 1 over many trades, and if the probabilities remain stable, you can *expect* to make an average of $12.00 per trade.
To put it in simpler terms, the calculations are demonstrating an example of how the Kelly Criterion can be used to determine position sizing and potential gains based on win and loss probabilities, risk-reward ratio, and the percentage of bankroll used per trade. In this example, if you stick to the specified risk-reward ratio and probabilities, you can *expect* to make an average of $12.00 per trade over the long term. However, it’s important to note that actual results can vary, and this example assumes consistent probabilities and risk-reward ratios, which may not always hold true in real-world trading situations.
Recommended Kelly fraction for currency pair:
The recommended Kelly fraction for currency pair trading depends on your risk tolerance and trading experience. Many traders use a “half-Kelly” approach, which offers 75% of the maximum profit with just 25% of the variance. This is considered a more conservative approach compared to using the full Kelly fraction, which can be quite risky, especially for beginner traders.
However, some traders prefer to use an even smaller fraction of the Kelly criterion, such as 20-25% of the full Kelly. This can further reduce the risk and volatility associated with trading while still providing a reasonable return on investment.
Ultimately, the choice of Kelly fraction depends on your personal risk tolerance, trading experience, and confidence in your trading strategy. It’s essential to use a Kelly fraction that aligns with your risk management goals and allows you to trade comfortably without excessive stress or emotional strain.
Kelly fraction vs Fixed Fractional Position
The Kelly fraction and fixed fractional position sizing are both methods used to determine the optimal position size in trading, including currency pair trading. However, they differ in their approach and calculations.
The fixed fractional position sizing involves allocating a fixed percentage of the trading account balance to each trade. For example, if the fixed percentage is set at 2%, and the trading account has a balance of $10,000, then the position size for each trade would be $200.
The main difference between the two methods is that the Kelly criterion takes into account the probability of success and the potential reward-to-risk ratio of a trade, while fixed fractional position sizing risks the same percentage of account equity on each trade regardless of the trade’s probability of success or potential reward-to-risk ratio. The choice between the two methods depends on the trader’s risk tolerance, trading experience, and confidence in their trading strategy.
Kelly criterion vs Martingale system
The Kelly criterion and the Martingale system are two different money management strategies used in forex trading. The main difference between them lies in their approach to position sizing and risk management.
The Martingale system is a betting strategy that originated in the gambling world and has been adapted to forex trading. The system involves doubling the size of a losing bet (or trade) until a winning bet (or trade) occurs, aiming to recover all previous losses and make a small profit. The Martingale system is based on the theory of mean reversion and assumes that a long enough losing streak is unlikely to occur.
In summary, the Kelly criterion is a more sophisticated money management strategy that takes into account the probability of success and the potential reward-to-risk ratio of a trade, while the Martingale system is a simpler approach that doubles the size of losing trades until a winning trade occurs, aiming to recover losses and make a small profit. The choice between the two methods depends on the trader’s risk tolerance, trading experience, and confidence in their trading strategy.
Applyin the Kelly Criterion in Volatile Markets:
In volatile markets, the Kelly criterion can lead to aggressive position sizing, as it aims to maximize long-term returns without considering drawdowns. This can result in large drawdowns that may be unbearable for most traders, especially in highly volatile forex markets.
In volatile markets, traders using the Kelly criterion should be cautious and consider combining it with other risk management strategies to protect their trading capital. Some traders may choose to use a smaller fraction of the Kelly criterion, known as “half-Kelly” or “fractional Kelly,” to account for the uncertainty in their predictions and reduce the risk associated with large drawdowns.
In summary, the Kelly criterion can help traders determine the optimal position size in forex trading, but its performance in volatile markets may lead to aggressive position sizing and increased risk. Traders should be cautious when using the Kelly criterion in volatile markets and consider combining it with other risk management strategies to protect their trading capital and manage risk effectively.
Does it help in Position Sizing?
Eventhough the Kelly criterion does not directly help traders determine their stop loss and take profit levels in forex trading. Stop loss and take profit levels are used to manage risk and maximize profits by setting predetermined price levels at which a trade will be closed. These levels are typically determined based on technical analysis, support and resistance levels, or other risk management strategies.
To calculate stop loss and take profit levels, traders can use various methods, such as support and resistance levels, moving averages, or indicator-based methods like the Average True Range (ATR). The choice of method depends on the trader’s preferred trading style and risk tolerance.
In summary, while the Kelly criterion helps traders manage their risk by determining the optimal position size, it does not directly help in setting stop loss and take profit levels. These levels are determined using other risk management strategies and technical analysis tools.
In conclusion, the Kelly criterion is a mathematical formula used to determine the optimal position size in forex trading based on the probability of a winning trade and the win-loss ratio. It aims to maximize the expected geometric growth rate of wealth while considering the probability of success and the potential reward-to-risk ratio of a trade. However, the Kelly criterion assumes known outcome probabilities, which is not the case with investments, and should be used with caution, especially by beginner traders.
The Kelly criterion can be compared to other money management strategies, such as the Martingale system, which focuses on recovering losses by doubling the size of losing trades until a winning trade occurs. The choice between these methods depends on the trader’s risk tolerance, trading experience, and confidence in their trading strategy.
Traders should be cautious when using the Kelly criterion in volatile markets and consider combining it with other risk management strategies to protect their trading capital and manage risk effectively. Common mistakes traders make when using the Kelly criterion include overestimating the accuracy of their predictions, ignoring risk management, overleveraging, relying solely on the Kelly criterion, not having enough data, and not adjusting for changing market conditions.