Risk management is one of the essential factors if you want to be a successful swing trader. It allows us to take the necessary precautionary measures to be successful.
With this, we will be able to see the size of the transaction proportionally to the percentage acceptable to lose. This and other things that we have to take into account when investing is that essential risk management.
1. What is the Kelly Criterion?
Many investors around the world think about the importance of diversification, and when it comes to investing money, that amount will be prudent depending on the stock or sector. Kelly's criterion is used to know how to manage your money. This criterion is simply to bet a predetermined portion of the capital and can be the opposite of intuition.
John Kelly developed this system, and this was created to help the company AT&T with some problems with noise and long-distance telephone signals. Soon it became known as a new way of interpreting the information rate. Today many people use it as a money management system to invest and gamble.
2. What composes this criterion?
This money management system can be explained very easily by a simple formula which is:
Kelly % = W - [(1-W)/R]
W: It's the probability factor of winning. It is the probability that trade is successful can also be defined as the percentage that a position is won.
R: This means the profit/loss ratio is calculated by dividing the total amounts of successful trades by the quantities of failed trades.
3. How do you use it?
Putting into practice this equation is straightforward, follow these steps:
First, you have to see what your last 50 or 60 transactions were. It can be seen immediately by either asking your broker or merely looking at your tax return. Kelly's criteria automatically assume the same standards that you used in the past means that if you are already an advanced trader and this information is previously recorded.
Calculate the W: The probability of winning is calculated straightforwardly. You have to divide the number of successful trades by the total number of both successful and unsuccessful transactions. The closer the unit is to this value, the better the result.
R Calculation: The profit/loss ratio that is calculated by merely dividing the average profit from successful trades by the loss from failed trades.
4. What does it tell you?
The percentage result that results from Kelly's equation means the size of the positions you should be taking. It means if you have an effect of 0.04, you have to take 4% of your capital with each trade. With this system, you will know how much you should diversify.
Also, the system requires a bit of logic, something to keep in mind is that no matter what result you get from Kelly's percentage. It is not a good idea to put more than 20% to 25% of your capital into a single trade. Otherwise, you could be taking extraordinarily high and dangerous risks.