What is Kelly standard betting and how can it be used in crypto trading?

The Kelly Rule, a mathematical technique that revolutionized gambling and investing, is applied to optimize bet sizes to maximize long-term wealth. The formula calculates optimal bet sizes based on winning odds, but its practical application requires adjusting for trading costs and psychological factors in volatile markets like cryptocurrencies.

This article explains what the Kelly criterion is, how it works, how it is used in crypto trading, its integration with the Black-Scholes model and the associated advantages and disadvantages.

What is Kelly's standard bet?

The Kelly Scale is a mathematical technique used in gambling and investing to calculate the optimal size of a series of bets. The main idea is to reduce the chance of financial risks by increasing the rate at which capital grows over time. The algorithm takes into account the probability of winning or losing a bet in addition to the profit-to-loss ratio.

The central principle of Kelly's criteria is to allocate the capital between bets according to the betting edge or advantage and the available odds. The goal of Kelly's criteria is to increase growth by reducing risk by allocating a portion of capital to margin.

A good Kelly ratio indicates the bet rate that maximizes the logarithm of predicted wealth and yields the strongest long-term growth rate. Although the Kelly criterion provides a theoretical approach, it is important to acknowledge that in practice adjustments may be necessary to accommodate variables including transaction costs, estimation uncertainty, and psychological aspects.

The history of the Kelly standard

The Kelly standard, named after its inventor John L. Kelly Jr., was developed in 1956 during his tenure at Bell Laboratories. Its use quickly spread to gambling and investments from its original purpose of optimizing the signal-to-noise ratio of long-distance communications.

However, these fields became aware of him only later, largely because of Edward O. Thorpe is the reason for the effort. In the year In the early 1960s, Thorpe revolutionized the gambling industry by “beating the dealer” by applying the Kelly criteria to blackjack card counting.

The formula gained more popularity in finance, especially in the 1980s, when investors and researchers realized how well it could manage portfolios and optimize risk. Kelly's criteria is a straightforward yet effective decision-making method that helps individuals and organizations maximize profits while managing risk appropriately.

How is the Kelly criterion calculated?

This is the formula for Kelly's criterion as f* = (bp – q) / b. F is the capital amount for the bet, p is the probability of winning, q is the probability of losing (1 – p) and b is the net odds earned on the bet (including the return on the stake).

This formula shows the ideal percentage of capital to bet to minimize the chance of failure and maximize the rate of growth. It strikes a balance between the need to avoid high losses and the goal of rapid expansion.

The Kelly Scale provides a methodical way of sizing bets based on the odds and insights involved in betting. Although it provides a good approach in theory, in practice, it is often necessary to make adjustments to take into account various aspects, including risk tolerance, transaction costs and feasibility.

Related: What is the Dow Theory and how does it apply to cryptocurrencies?

How to use the Kelly standard in crypto trading

Using the Kelly Standard in cryptocurrency trading involves several critical steps for efficient risk management and wealth maximization. Using market research and indicators, the trader must first determine the probability of various outcomes, such as the probability of cryptocurrency asset price movements. This is a possible assumption for any further decision-making.

The trader then formulates a risk management plan by specifying the maximum amount of capital they are ready to commit to a single transaction. This process ensures wise allocation of resources while helping to minimize potential losses. Moreover, to determine p and q loss in cryptocurrency trading requires market research, a deep understanding of market dynamics, analysis of historical data and sometimes sophisticated forecasting models due to the volatility and unpredictability of the market.

After setting the risk parameters, the trader uses the Kelly criteria formula to calculate the correct bet amount. Considering the odds, the banker's division is determined by winning odds and losing odds. In the context of the Kelly standard, “bankroll” refers to the total amount of money a gambler or investor has available to bet or invest.

At this point, volatility analysis is important because the high volatility of the crypto market can significantly affect the bet size and risk assessment. The process requires constant evaluation, and as market conditions change, bet sizes and probabilities must be adjusted accordingly. Traders need to be proactive and receptive to new information to optimize their strategies over time.

In the context of cryptocurrency trading, let's say a trader assesses a 60% chance of a coin appreciating using the Kelly criteria. Additionally, the trade has odds of 2:1, indicating that it is twice the amount that can be returned (b = 2).

To calculate the optimal bet size using Kelly's formula:

The calculated f * = 0.4 indicates that 40% of the merchant's bankroll represents the correct bet amount. This means that the trader has to devote 40% of their capital to this particular business. However, before making any investment decision, it is important to consider other aspects such as portfolio diversification, market conditions and personal risk tolerance.

Also, note that the above example presents a theoretical optimum that does not account for all real-world variables such as trading fees, slippage, or the psychological impact of a large bet on the trader. Although the Kelly Criterion provides a useful framework for identifying the optimal bet sizes, it should only be applied in conjunction with rigorous risk management techniques and consistent market research.

Black-Scholes model with Kelly criteria

The Black-Scholes model and the Kelly criterion are two different concepts with different applications in finance. The Black-Scholes model is a mathematical method used to determine the theoretical value of European-style options. It was produced by Fisher Black and Myron Scholes. By providing a framework for pricing options contracts based on variables including asset price, volatility, expiration and interest rates, options trading has changed the world.

However, John L. Kelly Jr.'s Kelly Criterion is a method used to determine the correct size of a bet to maximize long-term wealth creation, especially when the outcome is uncertain. The Kelly criterion and the Black-Scholes model are complementary tools in the market as they deal with different risk management and bet sizes respectively.

Related: What is Gresham's Law, and how does it relate to cryptocurrencies?

The benefits of the Kelly standard in crypto trading

The Kelly criterion offers several advantages when used in conjunction with crypto trading methods. By choosing the percentage of capital to use for each trade, it provides a systematic way to determine the optimal position size for each trade based on the trader's margin and risk limits, reducing the chance of significant losses in stressful market conditions.

The Kelly Standard promotes disciplined trading by emphasizing long-term growth over short-term gains. With a fixed capital allocation based on the expected peak on each deal, traders can ultimately increase their total income.

In addition, the Kelly Standard promotes a balanced and long-term trading strategy by helping traders avoid overextending their funds. This is especially true in the volatile and fast-moving world of cryptocurrency markets, where long-term success depends on effective risk management.

A flexible tool for traders with different risk tolerances and market perspectives, the Kelly Standard can be tailored to different trading styles and methods. Crypto traders can apply Kelly's criteria to their trading strategy to increase the consistency of their performance and increase their risk-adjusted returns.

Limitations of the Kelly standard in crypto trading

Although the Kelly Standard provides insightful information, there are certain limitations on how it can be used in cryptocurrency trading. Given the high volatility and unpredictability of cryptocurrency markets, Kelly's criterion presupposes the calculation of accurate probabilities and expected returns, which can be difficult. Extreme price fluctuations in crypto assets are often caused by non-financial factors, which complicates the calculation of accuracy.

External factors such as market sentiment, regulatory changes or technological breakthroughs for crypto trading are not taken into account by Kelly's criteria. These elements have the potential to significantly alter market dynamics and reduce the accuracy of Kelly's criteria calculations.

Additionally, traders may be exposed to significant losses during periods of market volatility due to the powerful position sizing technique of Kelly's standard. In cryptocurrency trading, where price fluctuations can be fast and high, it can quickly drain capital, resulting in significant losses.

Additionally, the rigid formulation of the Kelly criteria may not be adequate for different risk needs or business styles. Its application in different trading contexts may be limited by traders with different risk tolerances or strategies, who may consider it unrealistic or overly conservative.

This article does not contain investment advice or recommendations. Every investment and business activity involves risk, and readers should do their own research when making a decision.