This Day On The Street
Continue to site
ADVERTISEMENT
This account is pending registration confirmation. Please click on the link within the confirmation email previously sent you to complete registration.
Need a new registration confirmation email? Click here

Phil McDonnell Analysis: The Kelly Criterion -- Good or Bad?

TheStreet Premium Services

A complimentary preview
of Options-Profits Previews

Malandrino/NajarianWEBINAR: Sector Selection and Trading Strategies 6pm ET CLICK HERE FOR INVITE AND TO REGISTER

A reader recently asked about the Kelly Criterion and how it might apply to my options trading ideas. I think the topic deserves a longer discussion than my email response.

The Kelly Criterion was published in a paper in 1956 discussing optimal race track betting. In race track betting you either win or lose so the outcome is binomial. In the markets there are many possible amounts you can win or lose with varying probabilities. So strictly speaking you have to modify Kelly's formula to cover the full range of outcomes.

I wrote a book titled Optimal Portfolio Modeling published by Wiley Trading. One chapter of the book describes how to modify the Kelly formula to achieve an optimized value for the markets. However that only means that it is the optimal value for one single trade repeated over and over. It is not the best criterion to use in managing a portfolio.

The reason is that if the formula called for an optimal fraction of 20% to be invested in each position and you decide to have 10 positions then you are going to be investing 200% of your net worth. That would probably be way too much in most circumstances. Also the modified Kelly formula only takes into account optimizing expected return - it says nothing about reducing risk.

The other factor not being considered in a portfolio situation is that most stocks are correlated with the market. By investing in 10 positions one is not necessarily getting 10 independent positions because of the correlation. So unless one further modifies the formula to take into account the correlations one will tend to over trade and suffer more risk than is justified. In the later chapters of my book there is a detailed discussion of ways to adapt the formulas for risk, return and correlation.

OptionsProfits can be followed on Twitter at twitter.com/OptionsProfits

EXCLUSIVE OFFER: Jim Cramer's Protégé, Dave Peltier, only buys Stocks Under $10 that he thinks could potentially double. See what he's trading today with a 14-day FREE pass.



Check Out Our Best Services for Investors

Action Alerts PLUS

Portfolio Manager Jim Cramer and Director of Research Jack Mohr reveal their investment tactics while giving advanced notice before every trade.

Product Features:
  • $2.5+ million portfolio
  • Large-cap and dividend focus
  • Intraday trade alerts from Cramer
Quant Ratings

Access the tool that DOMINATES the Russell 2000 and the S&P 500.

Product Features:
  • Buy, hold, or sell recommendations for over 4,300 stocks
  • Unlimited research reports on your favorite stocks
  • A custom stock screener
Stocks Under $10

David Peltier uncovers low dollar stocks with serious upside potential that are flying under Wall Street's radar.

Product Features:
  • Model portfolio
  • Stocks trading below $10
  • Intraday trade alerts
14-Days Free
Only $9.95
14-Days Free
Dividend Stock Advisor

David Peltier identifies the best of breed dividend stocks that will pay a reliable AND significant income stream.

Product Features:
  • Diversified model portfolio of dividend stocks
  • Updates with exact steps to take - BUY, HOLD, SELL
Trifecta Stocks

Every recommendation goes through 3 layers of intense scrutiny—quantitative, fundamental and technical analysis—to maximize profit potential and minimize risk.

Product Features:
  • Model Portfolio
  • Intra Day Trade alerts
  • Access to Quant Ratings
Real Money

More than 30 investing pros with skin in the game give you actionable insight and investment ideas.

Product Features:
  • Access to Jim Cramer's daily blog
  • Intraday commentary and news
  • Real-time trading forums
Only $49.95
14-Days Free
14-Days Free
Top Rated Stocks Top Rated Funds Top Rated ETFs