GLOSSARY // Risk & Psychology
Kelly Criterion
The Kelly criterion is a formula for the bet size that maximizes long-run compound growth: Kelly fraction = edge / odds. In trading form, f = W - (1 - W) / R, where W is the win rate and R is the ratio of average win to average loss.
Full Kelly oversizes for trading. The formula assumes the win rate and payoff are known exactly and stable — in markets they are estimates from limited samples, and betting full Kelly on an overestimated edge means systematically overbetting into deep drawdowns (full Kelly routinely tolerates 50%+ equity swings). Practitioners who use it at all run half Kelly or quarter Kelly, trading some theoretical growth for survivability.
A system wins 55% of the time with winners equal to losers (R = 1). Kelly fraction = 0.55 - 0.45 / 1 = 0.10, or 10% of equity per trade. Full Kelly at 10% means a 10-loss streak cuts the account by 65%. Quarter Kelly, 2.5% per trade, holds the same streak to a 22.4% drawdown while keeping most of the compounding benefit.
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Educational only — not financial advice. Definitions simplified for clarity; markets are messier than definitions.