Should You Use the Kelly Criterion for Forex Trading?

Aug 27, 2021

The Kelly criterion is a famous mathematical formula that attempts to maximize your long-term capital growth.

In this post, I’ll apply it to a EURUSD breakout strategy and explain some of its potential shortcomings when applied to forex trading.

Traders often search for better position sizing methods to amplify their strategy’s edge.

The Kelly criterion is one option that often pops up in forex forums.

Since it is particularly popular in the gambling world, it naturally attracts much skepticism from traders.

Is it really that bad? Let’s find out!

What’s the Kelly Criterion?

The Kelly criterion is used to determine the optimal bet size that will maximize your strategy’s long-term returns.

To apply it, you need to know your strategy’s win rate and expected returns.

Here’s how it’s calculated for gambling:

Let’s start by determining the value of b.

For example, if your strategy contains a $10 stop loss and a $10 profit target, b will be 1.

If you raise your profit target to $20, without moving your stop loss, b will be 2.

For a strategy with an equal stop loss and profit target (1-to-1 odds in gambling), and a 60% win rate, the Kelly criterion produces an optimal bet size of 20% of your account.

If your strategy’s expectancy (average trade) is zero, the Kelly criterion wisely gives you a bet size of zero.

You can use this Kelly calculator to speed up the process.

Applying the Kelly Criterion to Forex

To evaluate the usefulness of the Kelly criterion, I’ll apply it to a 15-minute EURUSD strategy.

This strategy uses the CCI indicator to detect breakouts, and has a 150-pip stop loss and profit target.

Here’s an example of the strategy in action:

When trading a fixed 0.1 lots throughout the backtest, the strategy yields a pleasant equity curve from 2003 to 2021.

Now let’s apply the Kelly criterion.

With a win rate of 57%, the Kelly criterion tells me I should risk 14% of my account per trade.

Backtest Results

Returns are spectacular! After 587 trades, my account grew from $5000 to $210 000, a 4100% return.

Returns are only part of the equation though.

Unfortunately, with an 8-trade losing streak, the strategy had a whopping 71% maximum drawdown.

With such a drawdown, you’ll need 250% returns just to break even. This is the price to pay if you’re after massive returns.

Traders often overestimate the amount of drawdown they can tolerate in real-time.

Backtests offer the benefit of hindsight; in reality you’ll have to trade through the drawdowns without knowing whether your account will recover.

I’ll need to lower the strategy’s drawdown by risking a smaller fraction of capital per trade. Let’s run the numbers.

Tailoring Fixed Fractional Position Sizing

I varied the fraction of account risked from 1-8%, as shown:

If I were to trade this strategy in isolation, I wouldn’t risk more than 4% per trade, which produces a 27% maximum drawdown.

At this risk level, the strategy still achieved a 9% annual return over 18 years. Nothing like the Kelly returns, but at least I won’t lose sleep at night.

If you’re hungry for better performance, a prudent option will be to trade a portfolio of uncorrelated strategies. Returns are additive, but drawdowns are not, thus giving you better risk-adjusted performance.

Why the Kelly Criterion Isn’t Recommended for Forex Trading

There are two reasons why I believe the Kelly criterion is better suited to the realm of gambling.

1. Does Not Consider Risk

From the example above, you can see the Kelly betting fraction tends to produce huge drawdowns.

This is because its sole purpose is to maximize your long-term returns, without taking drawdown into consideration.

Drawdowns above 50% would be unbearable for the majority of traders.

Even if you’re emotionally detached from drawdowns, be wary that a backtest only represents a single historical run for the strategy. If I were to take the strategy above and trade it for the next 18 years, the equity curve would look different.

For the backtest above, I got lucky because the strategy performed fairly consistently over time. If my losing streak had been longer than 8 trades, the 14% bet size could have resulted in a margin call.

You can simulate alternative backtest runs by randomizing your trade sequence. StrategyQuant’s Monte Carlo simulator can help with this.

2. Only Applies to Binomial Outputs

The Kelly criterion has the following requirements:

  • Every trade either results in a win or a loss
  • Your win and loss amounts are fixed

For the EURUSD strategy above, each trade would result in either a 150-pip gain or loss.

If you use a fixed stop loss and profit target for your strategy, this won’t be a problem.

But if your trade management includes trailing stops, time stops, or indicator-based exits, you won’t know your win/loss amount in advance.

For example, if you’re a long-term trend follower who lets your profits run, your winning trades could be anywhere from 1 to 1000 pips.

Consider the trade distribution below, taken from a trend following strategy.

The Kelly criterion cannot meaningfully analyze such a distribution, which severely limits its usefulness in trading.

Wrapping Up

The Kelly criterion is an aggressive position sizing method that serves to maximize your long-term returns, without taking drawdowns into consideration.

Statistics will vary for different strategies, but most traders will likely find the Kelly-induced drawdowns to be unbearable.

Together with its limited applicability to most trading strategies, I can only recommend the Kelly criterion if you’re taking part in a trading contest, or going for broke in the short-term.

Powered By

Development Platform

Forex VPS

FXVM Forex VPS

Popular Posts

Laguerre RSI Trend Following Strategy

The Laguerre RSI attempts to improve the responsiveness of the regular RSI, whilst keeping whipsaw trades to a minimum. Let’s see how well it detects short-term pullbacks for a trend following strategy!

read more

What is Fixed Ratio Money Management?

Have you heard of fixed ratio money management? How does it compare to the popular fixed fractional approach? Here I’ll explain how fixed ratio works, and see how it stacks up against fixed fractional money management.

read more

Build a Diversified Portfolio With QuantAnalyzer

The ability to efficiently trade a diversified portfolio of strategies is one of the biggest advantages of algorithmic trading. Here we will use QuantAnalyzer’s Portfolio Master to build a portfolio consisting of high performing, uncorrelated strategies.

read more

What Is the QQE Indicator?

The QQE is a mysterious indicator that sometimes pops up in trading forums. Does it deserve a place alongside the more traditional momentum indicators like the RSI and CCI? Let’s add it to a trend following strategy to find out!

read more

Make your money work for you!

Get promotions, trading ideas and strategy development tips delivered to your inbox!

Comments

5 Comments

  1. Khari

    The Kelly Criterion value itself can’t be used in trading because it assumes even distribution in the probability of results based on the presumed win rate. In other words, you could get a KC value of 33% risk with a 50% win rate and this of course can’t work because 3 trades would wipe you out. In this example, the KC assumes that if you lose one trade you WILL win the next one because of the presumed 50% win rate.

    However, just because the value itself shouldn’t be used, doesn’t mean the math can’t be used to derive something useful. If you divide the KC value by a given number x, the result will be a value that has a probability distribution with a degree of x. So if a KC value of 25% is divided by 10, then 2.5% represents the optimum risk for a probability distribution that accounts for up to 10 consecutive losing trades.

    Your solution does this to some degree by lowing the value to some thing more feasible. But if you were to take a derivative of the KC value, you can get an optimal risk according to how likely your system is to lose x trades in a row. So if you backtest your strategy for a long time and found that the max consecutive losses were 5, if you were being aggressive, you could divide the KC value by 5. However any strategy has the possibility to generate more losses in the future so I would divide by a value greater than 5 in order to have a value that is more stable. I generally divide the KC value by 10 only trade strategies with 7 max consecutive losses or less.

    Reply
    • Wayne

      Hi Khari, fantastic points you raised there. To me, the Kelly criterion is a viable starting point for trading, as long as it’s tweaked to be more conservative.

      Reply
      • Benny

        Hi Wayne,
        Could you elaborate on what you mean by more conservative?

        Reply
        • Wayne

          Hi Benny, I would start by looking at the max historical drawdown. The Kelly criterion above produced a 71% max DD, which is likely too much for most people. If you really want to use it, perhaps take half (or even less) of whatever position size it proposes.

          Reply
  2. Mike

    Khari mentioned we can divide Kelly Criterion sizing to 5 (or more) based on the number of historical consecutive drawdowns. It actually reduces everthing to the typical of position sizing, 1-3%.
    Thenthere is no point to do KC.

    Reply

Submit a Comment

Your email address will not be published. Required fields are marked *

Trading Strategies

What’s the Best Time to Trade Forex?

What’s the Best Time to Trade Forex?

The forex markets are open 24/5, but not all hours are created equal. Here I dissect my broker data to determine the best time to trade forex.

Forex Weekend Gaps: Can You Exploit Them?

Forex Weekend Gaps: Can You Exploit Them?

Have you noticed that forex weekend gaps usually reverse within 3 days? Here I’ll program a mean reversion strategy to exploit gaps over the last 18 years!

Money Flow Index: An Improved RSI?

Money Flow Index: An Improved RSI?

The Money Flow Index is sometimes called the volume-weighted RSI. Can it outperform the RSI in this trend following strategy?

Automated Bollinger Bands Squeeze Forex Strategy

Automated Bollinger Bands Squeeze Forex Strategy

StrategyQuant’s BBWR indicator is the perfect tool to detect a Bollinger Bands squeeze. Here I explain how it’s calculated, and use it to program a breakout strategy for the AUDJPY!

Can a Trading Pause Improve Your Trend Following Results?

Can a Trading Pause Improve Your Trend Following Results?

A temporary trading pause can improve your win rate if you’re trend following a volatile market. Here I’ll program a trading pause into a simple breakout strategy, and test its effectiveness on the Widow Maker – the GBPJPY.

Laguerre RSI Trend Following Strategy

Laguerre RSI Trend Following Strategy

The Laguerre RSI attempts to improve the responsiveness of the regular RSI, whilst keeping whipsaw trades to a minimum. Let’s see how well it detects short-term pullbacks for a trend following strategy!

How to Use the Supertrend Indicator

How to Use the Supertrend Indicator

Despite its cool name, the Supertrend indicator often seems to slip under the radar. Here I explain how it’s calculated, and combine it with moving averages to produce a simple trend following strategy.

Ichimoku Trend Following Strategy

Ichimoku Trend Following Strategy

Like candlesticks, the Ichimoku indicator is a fine Japanese creation. Here I’ll explain how the Ichimoku is plotted, and use it to build a trend following strategy for the USDJPY.

Strategy Development

Do You Know Your System Quality Number?

Do You Know Your System Quality Number?

The System Quality Number measures the profitability & consistency of your trading system. Here’s how to calculate your SQN and use it to improve your trading!

How to Get a Realistic Backtest Spread

How to Get a Realistic Backtest Spread

Your choice of backtest spread can certainly make or break a strategy. This post will show you how to study the intraday spread variations of your market, and suggest several ways to avoid paying ridiculous spreads.

Do You Know Your Strategy’s Optimization Profile?

Do You Know Your Strategy’s Optimization Profile?

Your strategy’s optimization profile often reveals its robustness, helping you select strategies that will remain profitable in live trading. Here I explain why an optimization profile is important, and how you can easily obtain one using StrategyQuant’s optimizer.

Which MT4 Backtest Report Metrics Should You Use?

Which MT4 Backtest Report Metrics Should You Use?

Understanding your backtest report is an essential part of being a successful strategy developer. Here I explain what the numbers mean, and how you can make use of each metric during strategy development.

Out-of-sample Testing Using Monte Carlo Simulations

Out-of-sample Testing Using Monte Carlo Simulations

Traders often use Monte Carlo simulations to estimate worst-case drawdowns, but did you know they can be used for out-of-sample testing too? This post demonstrates the use of StrategyQuant’s Monte Carlo simulator to randomize historical prices and strategy parameters, helping you select robust strategies for live trading.

How Many Trades Should Your Backtest Have?

How Many Trades Should Your Backtest Have?

We all want a large sample of trades in our backtests, but practical limitations such as data availability often get in the way. Here I’ll explain why 30 trades is insufficient, and how you can use standard error to quantify the uncertainty arising from a small sample size.

Build a Diversified Portfolio With QuantAnalyzer

Build a Diversified Portfolio With QuantAnalyzer

The ability to efficiently trade a diversified portfolio of strategies is one of the biggest advantages of algorithmic trading. Here we will use QuantAnalyzer’s Portfolio Master to build a portfolio consisting of high performing, uncorrelated strategies.

Strategy Optimization Using MT4

Strategy Optimization Using MT4

How do you improve your trading strategy in MT4? This post will show you how to optimize the entry and exit parameters for a moving average crossover strategy. Finally, an intraday time filter will be added to help avoid false breakouts.

Debugging & Backtesting Using MT4

Debugging & Backtesting Using MT4

With a fresh algorithm at your fingertips, how do you verify that it has been programmed correctly? This guide will show you how to use Metatrader 4’s visual backtester to debug and backtest your strategy.

Create Your Trading Algorithm in 15 Minutes (FREE)

Create Your Trading Algorithm in 15 Minutes (FREE)

Converting your trading idea into an algorithm is the first step towards reaping the benefits of automated trading. This guide will cover the creation of a simple moving average crossover algorithm, without any actual programming.

What Is Drawdown in Trading?

What Is Drawdown in Trading?

Are you getting a comprehensive assessment of your strategy’s downside? This post will discuss several methods to measure drawdowns, helping you build and select strategies that better suit your risk appetite.

Live Trading

What’s the Best Time to Trade Forex?

What’s the Best Time to Trade Forex?

The forex markets are open 24/5, but not all hours are created equal. Here I dissect my broker data to determine the best time to trade forex.

How to Find a Real Trading Guru

How to Find a Real Trading Guru

Every day I come across a trading guru offering educational content on the internet. Many of them speak of huge returns with minimal effort. Should these be trusted? Here’s some tips on how to separate the wheat from the chaff.

How to Enjoy Stress-Free Trading

How to Enjoy Stress-Free Trading

Trading is a great way to make some additional income, but not if you’re constantly pulling your hair out. Here I offer 7 tips to help make your trading profitable and stress-free.

How to Select the Best Forex VPS

How to Select the Best Forex VPS

A virtual private server (VPS) is a virtual computer that you can rent and access remotely. It provides a reliable platform on which to execute your forex strategies. This post will help you decide whether you need a VPS, and show you how to select an optimal VPS.

Make your money work for you!

Make your money work for you!

 

Get trading ideas and strategy development tips delivered to your inbox!

Thanks for subscribing!

Pin It on Pinterest

Share This