The Kelly Criterion is a method used to determine the optimal proportion of funds to bet or invest, and it is also applicable to cryptocurrency futures trading. Through the Kelly Criterion, traders can calculate the optimal proportion of funds that should be invested in each transaction to maximize long-term returns.
Kelly Criterion
The basic form of the Kelly Criterion is as follows:
f∗=bp−qbf^* = \frac{bp - q}{b}f∗=bbp−q
in:
f∗f^*f∗ is the recommended capital allocation ratio (i.e. the percentage of capital in each trade).
bbb is the odds of the trade (i.e. the multiple of profit).
ppp is the probability of winning.
qqq is the probability of failure (i.e., 1−p1 - p1−p).
In cryptocurrency contract trading, the specific steps for applying the Kelly formula are as follows:
Step 1: Determine the odds of the trade (b)
The odds bbb can be calculated by the ratio of expected return to risk. For example, if you think that a successful transaction can get a 2x return (i.e. a 1:2 risk-return ratio), then b=2b = 2b=2.
Step 2: Estimate the probability of winning (p)
The winning probability ppp is your confidence in the success of a transaction. If you think a transaction has a 60% chance of success, then p=0.6p = 0.6p=0.6.
Step 3: Calculate the probability of failure (q)
The failure probability qqq can be obtained by 1−p1 - p1−p. If p=0.6p = 0.6p=0.6, then q=1−0.6=0.4q = 1 - 0.6 = 0.4q=1−0.6=0.4.
Step 4: Apply Kelly's Criterion
Substitute the above values into the Kelly formula to calculate the recommended capital allocation ratio. For example, if b=2b = 2b=2, p=0.6p = 0.6p=0.6, then:
f∗=2×0.6−0.42=1.2−0.42=0.82=0.4f^* = \frac{2 \times 0.6 - 0.4}{2} = \frac{1.2 - 0.4}{2} = \frac{0.8}{2} = 0.4f∗=22×0.6−0.4=21.2−0.4=20.8=0.4
This means you should invest 40% of your capital in this trade.
Precautions
Conservative application: The calculation results of the Kelly formula may suggest investing too high a proportion of funds. In order to reduce risk, many traders will use a portion of the proportion recommended by the Kelly formula (for example, 50% or 30%).
Accurate probability assessment: The effectiveness of the Kelly formula depends on an accurate assessment of the probability of winning. If your probability assessment is inaccurate, it may lead to improper fund management.
Avoid over-trading: Although the Kelly formula can help optimize capital allocation, you should not rely too much on it for frequent trading. It is equally important to maintain good trading discipline.
By using the Kelly formula properly, traders can manage risks and funds more effectively in cryptocurrency contract trading and optimize long-term returns.