The Kelly Formula in Futures Trading

The Kelly Formula as well as the Kelly Criterion are well known in futures trading, but often misunderstood and used incorrectly. They were developed in 1956 by J.L. Kelly, an engineer for Bell Labs.

The formula was used to calculate the maximum exponential rate of transmission of our voices through the phone lines. We will use the formula to calculate the maximum exponential rate of return of our money by our commodity futures trading system.

This means there is a percentage to bet that will maximize our commodity trading returns. If we bet less than this optimal amount, our returns will be less and if we bet more than this optimal amount, our returns will also be less. This optimal amount is called the Kelly Criterion.

By betting more than the Kelly Criterion, we will not only diminish our returns, but increase our risk. So, at the very least, we want to err on the side of betting less. The Kelly Formula is very simple, but again often misunderstood when applied to trading mechanical systems.

The formula is our Expectation in percent divided by our payoff ratio. In our example, if our Expectation in percent is 33.14 and our payoff ratio is 2.26, then our Kelly Criterion would be 14.66% (.3314 / 2.26). This is the maximum amount we should risk in our account at any one time.

This is where the Kelly Formula usually gets misinterpreted. It does not mean that we can trade up to 14.66% of our account per trade. It means if we trade this strategy with $120,000, then we will be able to take on $17,592 of total risk (.1466 * $120,000). If our average risk per trade is $1,085, then we can have no more than 16 trades in our account at any one time ($17,592 / $1,085).

By using the Kelly Formula, we now know where the maximum exponential growth rate of our system is. At the very least, in this example, we know we don’t want more than 16 trades in our account at any one time.

The Kelly Formula is very useful; however, it doesn’t address drawdown. And, as we know, managing drawdown is crucial to long-term success as a trader.

At Commodity Trading Solutions, the Kelly Formula is one of the tools we use to maximize the returns of our strategies.

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Futures and options trading involve substantial risk. The valuation of futures and options may fluctuate, and as a result, clients may lose more than their original investment. In no event should the content of this website be construed as an express or an implied promise, guarantee or implication by or from Commodity Trading Solutions, LLC that you will profit or that losses can or will be limited in any manner whatsoever. Past performance is not necessarily indicative of future results. Information provided on this website is intended solely for informative purposes and is obtained from sources believed to be reliable. Information is in no way guaranteed. No guarantee of any kind is implied or possible where projections of future conditions are attempted.