Using the Kelly criteria, a mathematical technique that transformed betting and investing, bet sizes were optimized to maximize wealth over the long run. The algorithm determines the best bet amounts based on the likelihood of winning, but in real-world applications, it needs to be adjusted for transaction costs and psychological aspects in erratic markets such as cryptocurrency.
This article will define the Kelly criteria, describe its application in cryptocurrency trading, compare it to the Black-Scholes model, and discuss the advantages and disadvantages of using it.
How Does Kelly Criterion Betting work?
A mathematical method used in gambling and investing to determine the optimal size of a series of bets is called the Kelly criterion. The main idea behind it is to raise the pace of capital growth over time while reducing the likelihood of financial problems. The algorithm considers not only the possible profit-to-loss ratio but also the probability of winning or losing a wager.
The main idea behind the Kelly criterion is to divide up one’s money amongst wagers based on the edge or advantage of each wager and the odds that are offered. By allocating a percentage of money to the edge, the Kelly criterion seeks to maximize growth while limiting risk.
A bet size that maximizes the expected logarithm of wealth and produces the best long-term growth rate is referred to as having a good Kelly ratio. It is crucial to recognize that while the Kelly criterion offers an ideal theoretical approach, in practice, modifications can be required to account for factors like transaction costs, uncertainty in estimation, and psychological issues.
The Kelly Criterion History
Developed in 1956 by John L. Kelly Jr. while working at Bell Laboratories, the Kelly Criterion bears his name. Its original application, to maximize the signal-to-noise ratio in long-distance communications, soon extended to gambling and investing.
Nevertheless, mathematician Edward O. Thorp’s work were largely responsible for these fields’ later awareness of it. With the publication of his book “Beat the Dealer,” Thorp revolutionized the gaming business by using the Kelly criterion to blackjack card counting in the early 1960s.
The method became even more well-known in the finance world, particularly in the 1980s when researchers and investors discovered how effectively it could optimize risk and manage portfolios. The Kelly criteria is a simple yet powerful decision-making tool that assists people and businesses in maximizing profits while appropriately controlling risk.
How does one compute the Kelly criterion?
The Kelly criteria formula is expressed as f* = (bp – q) / b. F represents the percentage of capital to bet, p stands for winning, q for losing (1 – p), and b stands for net odds gained from the wager (including the stake return).
This formula shows the optimal capital percentage to bet in order to maximize growth rate and reduce failure probability. It achieves a balance between the need for protection against large losses and the objective of quick growth.
A systematic approach to sizing bets based on odds and perceived edge in a wager is provided by the Kelly criterion. In practice, it is frequently required to make adjustments to account for many factors, such as risk tolerance, transaction costs, and uncertainty in probabilities, even though it theoretically offers the best method.
How to Apply Kelly Criterion to Trading Cryptocurrency
Several essential steps must be taken while using the Kelly criterion in cryptocurrency trading in order to effectively manage risk and maximize wealth. The trader must first ascertain the likelihood of various outcomes, such as the possibility of a cryptocurrency asset’s price movement, using market research and indicators. This probabilistic estimate serves as the foundation for all subsequent decision-making.
After that, the trader creates a risk management strategy that specifies the maximum amount of capital they are willing to risk on a single deal. This process helps to minimize potential losses while guaranteeing prudent resource allocation. Because of the market’s inherent volatility and unpredictability, figuring out p and losing q in cryptocurrency trading also requires market research, a thorough understanding of market dynamics, historical data analysis, and, occasionally, advanced predictive models.
After establishing the risk parameters, the trader applies the Kelly criterion algorithm to determine the optimal bet size. It considers the chance of winning, losing, and the odds to determine how much of the bankroll should be wagered. Within the framework of the Kelly criterion, “bankroll” denotes the entire sum of money that an investor or gambler has at their disposal for making bets or investments.
Volatility research is now crucial since the extreme volatility of the cryptocurrency market can have a big impact on risk assessment and bet sizing. The procedure needs to be continuously reviewed, and bet quantities and odds need to be modified in response to shifts in the market. Traders need to be on the lookout for new information and flexible in order to optimize their methods over time.
In the context of cryptocurrency trading, let’s say a trader determines the probability that a certain coin would increase in value by 60% using the Kelly criterion. Additionally, the deal has odds of 2:1, meaning that a return of double the amount risked (b = 2) is feasible.
Using the Kelly criterion formula, determine the ideal bet size as follows:
The optimal bet amount is 40% of the trader’s bankroll, according to the computed f* = 0.4. This indicates that 40% of the trader’s capital should be allocated to this particular transaction. However, it’s important to consider a variety of factors, including market conditions, personal risk tolerance, and portfolio diversification, before making any investment decisions.
Furthermore, keep in mind that while the aforementioned example offers a theoretical optimum, it could not take into consideration all real-world factors, such as transaction costs, slippage, or the psychological effects of big bets on the trader. The Kelly criterion provides an effective framework for determining the optimal bet sizes, but it should only be used in concert with comprehensive risk management strategies and ongoing market analysis.
The Kelly criterion and the Black-Scholes model
Two separate ideas in finance, the Black-Scholes model and the Kelly criterion, have different uses. The theoretical cost of European-style options can be estimated mathematically using the Black-Scholes model. Myron Scholes and Fischer Black devised it. It revolutionized the world of options trading by providing a framework for pricing contracts based on variables such as interest rates, time to expiration, volatility, and the price of the underlying asset.
But in cases where the conclusion is uncertain, one technique that can be utilized to maximize long-term wealth generation is the Kelly criterion developed by John L. Kelly Jr. The Black-Scholes model and the Kelly criterion are complementing tools in the market since they deal with various facets of bet sizing and risk management, respectively.
Benefits of the Kelly Criterion for Cryptocurrency Trading
Combining the Kelly criterion with cryptocurrency trading strategies has several advantages. By choosing the percentage of capital to commit to each deal, it offers a methodical technique to calculate the optimal position size for every trade based on the trader’s edge and risk tolerance, reducing the likelihood of significant losses in volatile market conditions.
The Kelly criterion prioritizes long-term growth over short-term gains, which encourages traders to adopt a disciplined approach to trading. Traders may finally increase their total returns by allocating capital continuously based on the perceived edge of each deal.
The Kelly criterion also helps traders avoid overleveraging or underutilizing their capital, which promotes a long-term, well-rounded trading approach. This is particularly important in the fast-paced, highly volatile world of cryptocurrency markets, where successful risk management is essential to long-term success.
The Kelly criteria is a versatile instrument that can be adjusted to suit various trading approaches and styles, making it suitable for traders with a range of risk tolerances and market viewpoints. By adding the Kelly criterion into their trading methods, cryptocurrency traders can improve their risk-adjusted returns and performance consistency.
The Kelly Criterion’s Limitations in Cryptocurrency Trading
The Kelly criteria has several restrictions on its applicability to bitcoin trading, despite the fact that it offers valuable information. Due to the great volatility and unpredictability of cryptocurrency markets, it might be challenging to precisely calculate probabilities and projected returns in order to meet the Kelly criterion. Accurate probability calculations are made more difficult by the fact that non-financial factors regularly contribute to excessive price swings in crypto assets.
The Kelly criterion does not account for outside factors such as market sentiment, legislative changes, or technological advancements unique to the cryptocurrency industry. These factors have the power to significantly change market dynamics and lower the computation accuracy of the Kelly criterion.
Furthermore, the Kelly criterion’s aggressive position size methodology may expose traders to large losses during periods of market volatility. In cryptocurrency trading, where price movements can be large and sudden, such drawdowns can quickly deplete funds and result in considerable losses.
Furthermore, varied risk appetites and trading styles may not be sufficiently taken into account by the strict Kelly criterion formula. Because it is unrealistic or overly conservative, traders with different risk tolerances or strategies may limit its application in different trading scenarios.
