Kelly Criterion
The Kelly Criterion is a formula for determining optimal position size based on the probability of winning and the win/loss ratio. It maximizes long-term account growth but can produce large drawdowns at full Kelly.
Definition
The Kelly Criterion was developed by John Kelly at Bell Labs in 1956 and is used by professional gamblers, hedge funds, and systematic traders. It outputs the mathematically optimal fraction of capital to risk per trade given your edge. Most traders use 'fractional Kelly' (25-50% of full Kelly) to reduce volatility. Full Kelly can produce 50%+ drawdowns even when the underlying edge is positive.
Formula
Kelly % = (Win Probability × Win Ratio − Loss Probability) ÷ Win Ratio
Example
60% win rate, 1:2 R:R: Kelly = (0.6 × 2 − 0.4) ÷ 2 = 40%. Most traders would use half-Kelly (20%).