Kelly Criterion: Optimal Sizing for Known Edges

What Is the Kelly Criterion?

The Kelly Criterion is a formula developed by John Kelly in 1956 for determining the optimal bet size when you have a known edge. In trading, it answers: given your strategy's win rate and reward/risk ratio, what percentage of your capital should you risk per trade to maximize long-term growth?

The Formula

Kelly % = W – [(1 – W) / R]

Where:
W = Win rate (as a decimal)
R = Reward/Risk ratio (average win ÷ average loss)

Example: Win rate = 55%, average win = 1.5× average loss
Kelly = 0.55 – [(1 – 0.55) / 1.5] = 0.55 – 0.30 = 0.25 (25%)

The Full Kelly Problem

A 25% risk per trade sounds aggressive — because it is. The full Kelly maximizes long-term growth rate but also maximizes volatility. A 25% risk with a few consecutive losses creates enormous drawdown. Most professional traders use a fraction of the Kelly — typically half-Kelly (12.5%) or quarter-Kelly (6.25%) — to reduce volatility while capturing most of the growth advantage.

Kelly in Practice

The Kelly Criterion requires accurate inputs — and in trading, win rates and R:R ratios fluctuate. Kelly is best used as a framework for thinking about sizing relative to edge strength, not as a precise calculator. A strategy with a 30% Kelly output should be sized larger than one with a 10% Kelly output — but neither should be traded at full Kelly in live markets.