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Investing in stocks using the Kelly criterion money management strategy
In order to reduce your investment risk you have to diversify. The problem is that many traders do not know how to put the diversification concept into practice. How do we know the number of stocks to invest in and the percentage of equity to put in each one of these stocks? When to invest in more stocks and when to reduce our exposure?
The Kelly criterion attempts to provide an answer to all these questions. This money management strategy is based on two concepts, which are the Winner probability (Probability of a given trade to provide a positive return) and the Win/Loss ratio (The percentage of winners among all trades).
John Kelly, the developer of the Kelly criterion technique used these two ratios to create what is called the Kelly percentage. It is a value, expressed in percentage, which tells us how much we should invest in each stock.
Depending on the performance of past trades, Kelly criterion may tell us to invest all our money in three stocks or it may tell us to invest in more than 20 stocks (investing in highly diversified portfolio).
The money management script, based on the Kelly criterion technique, I have developed here allows you to specify two inputs.
The number of past trades: This is the total number of past trades the money management will use to calculate the Kelly percentage value. A value of 0.5 indicates that we should invest 50% of our equity in a single stock and therefore our portfolio will be composed of only two stocks.
The maximum number of positions: This is the maximum number of positions we should hold in a given period. If the Kelly percentage returns a value of 1% (This means that we should invest in 100 stocks) and the maximum positions is set to 50, then our trading system will invest in only 50 stocks. This prevents us from investing in portfolios that are too diversified.
Using the Kelly criterion strategy is very simple. After you download the current script, here are the different steps that should be performed:
- Update a trading system
- Select the "Money Management" tab
- Click on "Add an existing money management script"
- Select the Kelly criterion item
This script generates also a metric called "Kelly %" that returns the Kelly percentage value over time.
You can display this metric by dragging it from the "Select a time-series" list in the simulation report then dropping it into the strategy equity chart.
Trading financial instruments, including foreign exchange on margin, carries a high level of risk and is not suitable for all investors. The high degree of leverage can work against you as well as for you. Before deciding to invest in financial instruments or foreign exchange you should carefully consider your investment objectives, level of experience, and risk appetite. The possibility exists that you could sustain a loss of some or all of your initial investment and therefore you should not invest money that you cannot afford to lose. You should be aware of all the risks associated with trading and seek advice from an independent financial advisor if you have any doubts.
