The Kelly criterion, a mathematical strategy that revolutionized gambling and investing, was applied to optimize bet sizes for maximizing long-term wealth. The formula calculates optimal bet sizes based on winning probabilities, but its practical application requires adjustments for transaction costs and psychological factors in volatile markets like cryptocurrencies.
This article will explain what Kelly criterion is, how it works, how it can be used in crypto trading, juxtaposition with the Black-Scholes model, and the associated benefits and pitfalls.
What is Kelly criterion betting?
The Kelly criterion is a mathematical technique used in gambling and investing to calculate the ideal size of a sequence of bets. Its fundamental idea is to minimize the chance of financial risks while increasing the rate at which capital grows over time. The algorithm takes into account the likelihood of winning or losing a bet in addition to the potential profit-to-loss ratio.
The Kelly criterion’s central tenet is to allocate one’s capital among bets according to the bet’s edge or advantage and the available odds. The goal of the Kelly criterion is to maximize growth while minimizing risk by assigning a portion of the capital to the edge.
A good Kelly ratio refers to a bet size that maximizes the predicted logarithm of wealth and yields the strongest long-term growth rate. It is imperative to acknowledge that although the Kelly criterion presents a theoretical ideal approach, in practice, adjustments may be necessary to accommodate variables including transaction expenses, estimation uncertainty and psychological aspects.
History of the Kelly criterion
The Kelly Criterion, named after its creator, John L. Kelly Jr., was formulated in 1956 during his tenure at Bell Laboratories. Its use quickly spread to gambling and investing from its original purpose of optimizing the signal-to-noise ratio in long-distance communications.
However, these fields only became aware of it later, mostly because of mathematician Edward O. Thorp’s efforts. Through the application of the Kelly criterion to blackjack card counting in the early 1960s, Thorp transformed the gambling industry with his book “Beat the Dealer.”
The formula gained further prominence in finance, especially in the 1980s, when investors and researchers realized how well it could manage portfolios and optimize risk. The Kelly criterion is a straightforward yet effective technique for decision-making that helps individuals and organizations maximize profits while properly managing risk.
How is the Kelly criterion calculated?
This formula for the Kelly criterion is represented as f* = (bp - q) / b. F is the proportion of capital to bet, p is the chance of winning, q is the probability of losing (1 - p), and b is the net odds earned on the bet (including the return of the stake).
This formula indicates the ideal percentage of capital to bet to minimize the chance of failure and maximize the growth rate. It strikes a compromise between the necessity for protection against significant losses and the goal of rapid expansion.
The Kelly criterion offers a methodical way to size bets according to the odds and perceived edge in a wager. Although it provides an optimal approach in theory, in practice, it is often necessary to make adjustments to take into account different aspects, including risk tolerance, transaction costs and uncertainty in probabilities.
Related: What is Dow Theory, and how does it apply to cryptocurrencies?
How to use Kelly Criterion in crypto trading
Using the Kelly criterion in cryptocurrency trading entails a number of crucial actions for efficient risk control and wealth maximization. Using market research and indicators, the trader must first determine the probability of different outcomes, such as the chance of a cryptocurrency asset’s price movement. The basis for any further decision-making is this probabilistic estimation.
The trader then develops a risk management plan, outlining the highest proportion of capital they are ready to stake in a single transaction. This procedure ensures wise resource allocation while assisting in reducing possible losses. Moreover, determining p and losing q in cryptocurrency trading involves market research, a deep understanding of market dynamics, historical data analysis and, sometimes, sophisticated predictive models due to the market’s inherent volatility and unpredictability.
The trader then uses the Kelly criterion formula to calculate the ideal bet size after setting the risk parameters. It determines the portion of the bankroll to bet by taking into account the odds, winning probability and losing probability. In the context of the Kelly criterion, “bankroll” refers to the total amount of money that a gambler or investor has available for betting or investing.
At this point, volatility analysis is essential because the crypto market’s high volatility can significantly impact bet sizing and risk assessment. The process requires constant reevaluation, and as market conditions change, bet sizes and probabilities must be adjusted accordingly. To maximize their strategies over time, traders need to be alert and receptive to new information.
Using the Kelly criterion in the context of cryptocurrency trading, let’s say a trader assesses the likelihood that a specific coin will appreciate by 60%. Furthermore, the trade has odds of 2:1, which indicates that the possible return is twice the amount wagered (b = 2).
To calculate the optimal bet size using the Kelly criterion formula:
The calculated f* = 0.4 indicates that 40% of the trader’s bankroll represents the ideal bet size. This means that the trader should commit 40% of their capital to this specific trade. However, before making any investing decisions, it’s critical to take other aspects like portfolio diversification, market conditions and personal risk tolerance into account.
Also, be aware that the above example provides a theoretical optimum that may not account for all real-world variables, such as transaction fees, slippage or the psychological impact of large bets on the trader. Although the Kelly criterion offers a useful framework for figuring out the ideal bet sizes, it should only be applied in conjunction with thorough risk management techniques and continuous market research.
The Black-Scholes model vs. the Kelly criterion
The Black-Scholes model and the Kelly criterion are two distinct concepts in finance with different applications. The Black-Scholes model is a mathematical method used to determine the theoretical price of European-style options. It was developed by Fischer Black and Myron Scholes. By offering a framework for pricing options contracts based on variables, including the price of the underlying asset, volatility, time to expiration and interest rates, it transformed the world of options trading.
However, John L. Kelly Jr.’s Kelly criterion is a method that can be used to determine the ideal size of bets to maximize long-term wealth creation, especially in situations where the outcome is unclear. The Kelly criterion and the Black-Scholes model are complementary instruments in the market because they address different aspects of risk management and bet sizing, respectively.
Related: What is Gresham’s law, and how does it relate to cryptocurrencies?
Advantages of Kelly criterion in crypto trading
The Kelly criterion offers several benefits when used in conjunction with crypto trading tactics. It provides a systematic way to determine the best position size for every trade depending on the trader’s edge and risk limits by selecting the percentage of capital to devote to each deal, decreasing the probability of substantial losses in turbulent market conditions.
The Kelly criterion promotes a disciplined approach to trading by emphasizing long-term growth above short-term gains. Through constant capital allocation based on the perceived edge of each deal, traders may eventually increase their total returns.
Additionally, the Kelly criterion encourages a balanced and long-term trading strategy by assisting traders in avoiding overleveraging or underutilizing their money. This is especially critical in the volatile and fast-moving world of cryptocurrency markets, where long-term success depends on effective risk management.
A flexible tool for traders with varying risk tolerances and market perspectives, the Kelly criterion can also be tailored to different trading styles and methods. Crypto traders can increase the consistency of their performance and boost their risk-adjusted returns by implementing the Kelly criterion into their trading strategies.
Limitations of Kelly criterion in crypto trading
Although the Kelly criterion provides insightful information, there are certain limitations on how it can be used in cryptocurrency trading. Given the extreme volatility and unpredictability of cryptocurrency markets, the Kelly criterion presupposes a precise calculation of probabilities and expected returns, which can be difficult. Excessive price fluctuations in crypto assets are frequently caused by non-financial causes, which complicates accurate probability calculations.
External elements like market sentiment, regulatory changes or technological breakthroughs specific to the crypto business are not taken into consideration by the Kelly criterion. These elements have the potential to greatly alter market dynamics and reduce the accuracy of the Kelly criterion’s computations.
Additionally, traders may be exposed to significant losses during times of market volatility due to the aggressive position sizing technique of the Kelly criterion. Such drawdowns can swiftly deplete capital in cryptocurrency trading, where price swings can be swift and substantial, resulting in significant losses.
Furthermore, the rigid formula of the Kelly criterion might not adequately account for different risk appetites or trading styles. Its application in various trading contexts may be limited by traders with varying risk tolerances or strategies, who may find it unrealistic or excessively conservative.
This article does not contain investment advice or recommendations. Every investment and trading move involves risk, and readers should conduct their own research when making a decision.
