The Kelly Criterion method of money management is well-known among gamblers as a way to administrate how much to bet when the odds are in your favour.
Created by day traders based on different statistical probability theories based on the work done at Bell Laboratories in the 1950s. The propose was to figure out the best conducts to manage signal-noise issues in long-distance telephone communications. Very quickly, the mathematicians who worked on it saw that there was a way to apply it into gambling.
The fundamental idea is that you should never place all of your money in a single trade, but instead put in an amount that is appropriate given the level of unpredictability. Otherwise, your risk can be to lose everything.
To estimate the ideal percentage of your betting bank to put at risk, you need to know what percentage of bets you are likely to win as well as the return from a winning trade and the ratio performance of winning bets to losing bets.
There’s is a “simple” way of understanding the method.
Imgine that with probability A you will make a profit of B times what you bet, and otherwise you lose the bet.
To get the optimum amount to bet is A = (1-A) / B
A is the percentage of winning bet, and B is the ratio of the regular gain of the winning bet relative to the average loss of the losing trades.
A – is a number from 0 to 1, so 50% probability will be 0.5
Eg. Imagine you have an equation that loses 40% of the time with a loss of 1% and that wins 60% of the time with a gain of 1.5%.
The Kelly formula will be, (percentage to trade) .60 – [(1 – .60)/(.015/.01)], or 33.3 percent.
So, you limit your trades to no more than 33% of your capital, and as such you should never exhaust your betting bank.