Can you use the Kelly criterion in crypto trading?

Understanding the Kelly criterion

The Kelly criterion refers to a mathematical technique used in gambling and investing; it was applied to calculate optimal bet sizes based on probabilities of winning and minimising risk. The formula calculates the likelihood of winning or losing a bet in relation to a potential profit-to-loss ratio. 

In simple terms, the Kelly criterion’s main purpose is to maximise profit gains over time and minimise risks – the formula is utilised to allocate users’ capital among bets in relation to the bet’s edge and potential odds. 

Originally developed to examine the disturbances in long-distance phone calls, the Kelly criterion formula was rapidly adopted by gamblers to calculate optimal betting sizes for their bets. 

Since then, investors and traders adopted the Kelly strategy to manage their portfolios and maximise their profit potential.

History of the Kelly criterion

This popular gambling and investing formula was created by John L. Kelly when he was working at the telecommunications company AT&T. John Kelly was working on analysing disturbances in long-distance phone calls which ended up publishing his findings in the 1956 ‘A new interpretation of information rate’ academic paper. 

The Kelly formula was soon adopted by professional gamblers in a less academic environment; gamblers used it to determine how much to bet on horse racing.  

In the early 1960s, the mathematician Edward O. Thorp applied the Kelly criterion to blackjack card counting and published the ‘Beat the Dealer’ book based on his findings. 

In the 1980s, the Kelly criterion gained more popularity among financial experts and investors when they realised that it was beneficial for portfolio management and risk optimisation.  

The Kelly strategy is claimed to be used by famous investors such as Warren Buffet, Charlie Munger, and the bond trader Bill Gross.

Now it is mainly used as a general portfolio management system in sports betting, gambling, investing, and trading. 

Sports betting is a popular activity among millions of people worldwide. To find out how the crypto space enhanced this area of interest, we suggest reading this article: 'Mastering Crypto Sports Betting Strategies: A Comprehensive Guide'.

The Kelly criterion formula - How to calculate the Kelly percentage?

The Kelly criterion encompasses two basic components. The first component is the winning probability or the probability of a positive outcome, while the second one refers to the total win-loss ratio. The second component is made of the total number of winning trades divided by the total number of losing trades. 

These components are input into the Kelly criterion equation to get the optimal trade size concerning the probability of the trade being positive.  

The output from the equation is known as the Kelly percentage. It has many applications such as portfolio management, bet size optimisation or determining the amount that should be allocated to each market sector or individual stock. 

The Kelly equation has: K%=W1WR where K% refers to the Kelly percentage, W equals win probability and R represents the win-lose ratio.

In other words, the Kelly percentage tells gamblers and investors how much they should risk on a particular gamble or investment.

Interpreting the results

After determining the right input and making the required calculations, the Kelly formula should provide a percentage of risk on each gamble, trade, or investment. For example, if a gambler gets an outcome of 0.035, they should risk 3.5% of their available funds on each bet.  

The result of the Kelly equation is a number that refers to the size of the position you should enter. As mentioned above, the number will be less than one. Once you multiply it by 100, you will get the percentage.  

However, keep in mind that responsibility is the main rule when it comes to investing or any other similar activities. Sometimes it is wiser to overrule the Kelly criterion to act responsibly and not lose more than you can afford to lose.

Is the Kelly criterion effective?

Many people wonder how a formula originally created to test telephone systems can be used for investing, gambling or trading. It presents a purely mathematical approach which is able to be tested in the long run. 

The Kelly criterion is considered to be effective. As long as the required components are entered accurately into the equation and calculated accordingly, the system should turn out to be effective. For example, an equity map could show its efficiency by setting out a simulation of growth based on pure maths.

However, the Kelly criterion is not ideal. While it is used efficiently to enhance risk management systems, portfolio diversification and managing money in general, it doesn't provide many other benefits. All factors need to be determined precisely into the mathematical formula for the system to work out.

What is a fractional Kelly bet?

Full Kelly criterion betting suggests that a person should set forth a percentage of their bankroll equal to the expected edge divided by odds – this is typically an aggressive strategy. In this aspect of this formula, bankroll refers to the entire sum of money that a person has at their disposal for making bets, investments or trades.

Within the gambling community, as well as the trading and investing space, the expected edge can be hard to precisely determine, and the odds could fluctuate. Since using the full Kelly criterion could lead to big losses, users tend to utilise a fractional Kelly criterion and wager only a fraction of the optimal full Kelly bet size. 

Using a fractional Kelly approach can reduce the risk of big downtrends while maintaining a positive value in the long run. Decreasing the Kelly percentage decreases the downswings while affecting potential profits only slightly.

What is the difference between the Kelly criterion and the Black-Scholes model?

If you google the Kelly criterion, you will bump into other models used in the world of finance that might have different applications. For example, the Black-Scholes model, created by Fischer Back and Myron Scholes, refers to a mathematical approach used to establish the theoretical price of European-style options.  

The Black-Scholes model laid down a framework that enhanced the options trading space, but it differs from the Kelly criterion. Using the Kelly criterion means that you are determining the ideal size of bets to maximise long-term profits, specifically in situations that might come off as unclear. 

However, these two approaches are often mentioned together because they are complementary tools in the market as they address different aspects of bet sizing and risk management. 

The crypto space is shaped by several theories that stem from traditional economics. If you want to learn more, check out this article: 'How do popular theories in economics shape crypto?'.

How to use the Kelly formula in crypto trading?

When gamblers use the Kelly criterion for their bets, they typically work with clear odds; for example, the American roulette wheel encompasses 48% odds of hitting red or black. 

On the other hand, traders work with odds that are more dynamic and make the use of the Kelly criterion a bit more complicated. 

The crypto market is associated with high volatility so taking several steps such as conducting market research is essential. To apply the Kelly criterion in cryptocurrency trading, users need to determine the possibility of the digital asset’s price movement by conducting past performance analysis and using indicators, along with advanced predictive models if needed. 

Utilising the Kelly strategy within the crypto trading space requires a higher level of knowledge as well as an understanding of crypto market dynamics; the trader typically proceeds with developing a suitable risk management strategy specifying the amount of capital they can afford to lose.  

Once the trader has efficiently determined the risk parameters, they can apply the Kelly criterion algorithm to establish the optimal bet size. Keep in mind that the process needs to be continuously assessed and modified to reflect the market changes.

A practical example

For example, imagine a crypto trader determining the probability that a particular coin could increase in value by 60% using the Kelly criterion with odds of 2:1 which means that a return of double the amount risked is attainable. 

The Kelly calculation should turn out to be something like this- the optimal Kelly bet size would be 40% of the trader’s bankroll according to the output of 0.4. Kelly criterion calculated means that 40% of the trader’s bankroll should be allocated to this transaction.  

However, the Kelly criterion is a purely mathematical approach, and the trader needs to additionally assess a variety of factors such as personal risk tolerance, portfolio diversification, and market conditions before making any trading or investment decisions. 

This system tells traders how much they should diversify but the theoretical approach doesn't require common sense.

However, traders can always stick to more conservative approaches of the Kelly criterion. For example, imagine a trader named John that has a strategy with an average win rate of 40% and a risk-reward ratio of 2. If he feeds this data into the formula, John gets a Kelly bet size of 10% as the output. 

This output just tells John to use 10% of his bankroll on each trade, but John prefers more conservative trading styles and decides to apply the fractional Kelly approach and risk 5% instead.

Can you use the Kelly formula in crypto investing?

The Kelly criterion can be applied to determine long-term growth, and it can be used to calculate the user’s investing advantage. However, long-term growth in volatile crypto markets depends on conducting a robust risk-averse approach. 

A precisely calculated Kelly ratio could help investors to maximise wealth and produce a well long-term return rate. Many investors tend to utilise a conservative allocation of funds to limit the risks of downtrend volatility on the cryptocurrency market.  

When allocating crypto assets, the Kelly formula can be applied to allocate across high-cap, mid-cap and low-cap assets. The underlying principle of the Kelly criterion is to allocate investors’ capital among positions based on a perceived edge and the estimated odds.  

While, for instance, precise blackjack card counters can execute such a strategy well due to parameters that are easier to calculate, crypto investments require constant reevaluation and adjustments of probabilistic outcomes.

Benefits of the Kelly criterion in crypto trading

Applying the Kelly criterion jointly with other crypto trading strategies provides a few benefits to crypto traders. It presents an educated and systematic manner to determine a suitable position size for each trade and decrease the possibility of potential losses. 

The Kelly strategy serves as a good supplement to a long-term trading strategy as an approach that requires constant monitoring and capital allocation based on the perceived edge of each trade. 

By implementing the Kelly criterion in a user’s trading system, they can increase the consistency of their trading performance. For example, for traders who prefer a conservative trading system, the fractional Kelly approach can help traders survive in the volatile crypto market. After all, keep in mind that ‘time in the market beats timing the market’.

Drawbacks of the Kelly criterion in crypto trading

The Kelly criterion is a very useful approach, but it is not without limitations. As mentioned above, a mathematical formula is only as good and reliable as the data it contains. 

The Kelly criterion assumes that the user follows the exact system, either trading, betting, or investing, with the same win rates and other data input during the time of Kelly calculations. If these data inputs change, calculations should be repeated to reflect the changes. 

In other words, you must put in work and constantly monitor your trading or investing performance which can be time-consuming and exhausting. 

Furthermore, using the Kelly criterion might not be suitable for certain types of traders and investors. For example, some users focus more on long-term risk minimisation while the Kelly approach is about finding optimal returns. When it comes to market volatility or portfolio allocation, the Kelly criterion doesn’t help a lot. 

If you decide to apply the Kelly criterion, monitor your performance and expected returns while reflecting the required changes. Whether you are using it within the crypto market or traditional financial markets, do not follow any strategy blindly yet exercise caution and responsibility. 

It is always best to do your own research. If you want to gain valuable insights into the world of cryptocurrency and crypto trading, take a look at the available courses at the Learn Crypto Academy.