Strategy and performance
Kelly criterion
A formula giving the position size that maximises long-run growth for a known edge. Its output is far too large for real trading, because the inputs are estimates and the drawdowns it accepts are extreme.
GFN’s figure
Kelly-sized positions are incompatible with a fixed floor: GFN's 8% 2 Step drawdown allows four consecutive 2% losses, and full Kelly routinely implies far larger fractions than that.
In detail
Kelly criterion,explained
Full Kelly assumes the win rate and payoff are known exactly. They never are, and overestimating an edge by a small amount produces a position size that is catastrophically wrong.
Most practitioners use a fraction - a quarter or less - which lands close to the 0.5% to 1% risk per trade that a prop account's drawdown floor makes practical anyway.
Related
Terms thatcome with it
Most rules only make sense next to the ones they interact with. These are the entries this one depends on.
Fixed fractional
Risking a constant percentage of equity on every trade, so position size falls after losses and rises after gains. It is the standard position-sizing model and the one most prop rules assume.
Position size
How many lots a trade is placed in. It is calculated from the dollar amount being risked and the stop distance, not chosen first - which is the reverse of how most traders approach it.
Risk of ruin
The probability that a sequence of trades takes an account to its breach level before it reaches its target, given a win rate, a reward-to-risk ratio and a risk per trade. It is driven mostly by position size.
Expectancy
The average result of a trade over a large sample, combining win rate and average win and loss. A positive expectancy is necessary for a strategy to work and not sufficient for it to pass an evaluation.
Maximum drawdown
The total loss an account may take before it is failed. Expressed as a percentage of the starting balance, it sets a floor: touch it and the account breaches, whatever the account has made up to that point.
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