What Is Kelly Criterion?
The Kelly Criterion, derived by John Kelly in 1956, calculates the position size that maximizes long-term geometric growth given a known edge. Formula: f = (bp - q) / b, where p = win probability, q = loss probability, b = win/loss ratio.
Kelly produces the mathematically optimal stake — but it assumes perfect knowledge of your edge, which traders never have. Using full Kelly with overstated edge guarantees ruin. Most practitioners use 'fractional Kelly' (half or quarter Kelly) to account for parameter uncertainty.
Kelly is more theoretical than practical for discretionary traders, but useful as a sanity check. If your strategy has a 55% win rate and 1.5:1 reward/risk, Kelly says risk ~17% per trade — which would feel insane in practice. The size you can actually tolerate emotionally is often well below Kelly.
Related terms
- Position Sizing — Determining how many shares or contracts to trade based on account size and risk tolerance.
- Expectancy — The average profit or loss per trade, given win rate and average win/loss size.
- Risk Management — The systematic process of identifying and controlling exposure to losses.
- Win Rate — The percentage of trades that close profitably out of total trades taken.