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  #1  
Old May 31st, 2011, 08:56 AM
matt21 matt21 is offline
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Default Kelly-betting for FX trading

I have a question regarding position sizing for trading the FX markets. If the moderators think it's more appropriate for this to be posted in another section, please do move the thread.

In my AP play I have been using the Kelly principle in determining how much to bet with various levels of edge and payoff. I have been using the formula of Edge%/Paypoff to determine the ratio of my BR that I should wager. Given warnings from established full-time gambling pros that AP's tend to overestimate their edge and to avoid the rollercoaster rides of full-Kelly betting I generally aim for half-Kelly bets.

As well as being an AP, I also speculate/trade in the FX markets, and am now trying to apply the Kelly theory to determine how much I should risk per trade. Many serious retail traders opt for risking no more than 1% of their BR per trade. I have one trading strategy which has been working quite well, in fact so well that I am heavily discounting the win rates in order to address the position size issue.

Assume therefore (conservatively) that there is a trading strategy - that creates 45% winners, 10% break-even and 45% losers. Losing trades result in a $1 loss. Winning trades result in a $1.30 gain [after all transaction costs]. This creates an EV of 13.5% per trade. This should be a very respectable edge for any AP. The other beauty here is that I have this edge every time that I have a setup that meets my requirements. When I dont have the setup then I dont trade. This is one major difference to my AP playing - I dont have any waiting bets in my FX trading. Though I might only have a half a dozen such opportunities per month.

Putting that into the Kelly formula we get 13.5%/1.3 = 10.38% implying that a full-size Kelly bet should be 10.38% of the BR. Half-Kelly would be 5.19% and quarter-Kelly would be 2.6%. At the moment I am only risking 1% per trade.

One argument that traders use for restricting themselves to 1% per trade is that it is psychologically difficult to see your BR decrease if you have several consecutive losing trades. However, I am quite used to psychologically deal with wins and losses from my AP experiences, so it seems that this reason shouldn't apply to me?

I am wondering whether anyone can comment as to whether it seems I should be increasing the amount I risk per trade? Is it wrong to apply the Kelly approach in this context? Also whether I have made any errors in my calculations?
  #2  
Old May 31st, 2011, 11:01 AM
MangoJ MangoJ is offline
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Quote:
Originally Posted by matt21 View Post
Assume therefore (conservatively) that there is a trading strategy - that creates 45% winners, 10% break-even and 45% losers. Losing trades result in a $1 loss. Winning trades result in a $1.30 gain [after all transaction costs]. This creates an EV of 13.5% per trade.
If you want to Kelly bet, you better know your edge, not assume something how the market will react. I'm sure you're doing well in normal days, but the single crisis is what will kill you.

Advantage play is something different, where you do know exactly what you're doing (at least you are supposed to). APs don't play games with unknown rules, or rules that are subject to change without notice (as in the crisis).
  #3  
Old May 31st, 2011, 01:59 PM
Midwestern Midwestern is offline
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matt,

please remember that kelly sizing for trades represents a profit-maximizing strategy. this says nothing about the portfolio's volatility in regards to its size (you'll see VaR, or Value at Risk, as well as the Sharpe Ratio, as the main statistics in this regard). Many traders size their trades much smaller than Kelly because they want their portfolio to have a lower volatility of returns.

if your particular trading strategy consistently yields these profit statistics, i wouldnt change a thing. Why? because this is your portfolio and the only person you are growing it for is yourself. i.e. no one will sweat the swings but you. HEDGE FUNDS out there have to worry about the public's perception about their performance and volatility. obviously they don't want their returns swinging +/- on a daily basis , so they under-size their trades relative to the size of their portfolio to give the portfolio an air of consistency.

its up to you and your risk tolerance, but if i found something with a 13% edge, id be betting the max kelly amount on my portfolio every darn time.
  #4  
Old May 31st, 2011, 02:05 PM
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zengrifter zengrifter is offline
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Cannot accurately apply Kelly UNLESS you know your advantage BEFORE you bet. zg
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Old June 1st, 2011, 10:25 AM
matt21 matt21 is offline
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MangoJ I think you make a good point. Though my trading strategy is very short term - the strategy in question has trade durations from 30min to several hours and the European and US markets are sleeping (well mostly) at the time that I apply the strategy. A crisis would be even less likely to occur during this time, but yes it still could.

Midwestern - agreed. Large hedge funds could not 'afford' to have high volatility in their returns, as they would then probably struggle to attract investors. I think this is one of the advantages that small traders have over deep-pocketed players.

Yes the trouble is that with the markets you can only use empirical and testing results as guidance for potential results, whereas with most AP strategies one should be able to precisely calculate the theoretical return and associated volatility.

Having thought about it, I have decided to gradually increase my risk per position (on established strategies) from 1% to 2.5%. Yes this will increase the volatility but if my win rates and Win:Loss ratio hold, then over 6-12 months I will also increase my net return by a factor of 2.5. Even with 2.5% risk I should theoretically still be way underbetting/undertrading my BR. The only reason why I questioned the 1% rule of thumb is thanks to the AP experiences that I ahve collected. Maybe that's where being AP provides additional insight to being a trader in the financial markets.
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Old June 2nd, 2011, 04:55 AM
blackriver blackriver is offline
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i think 2.5 is ok, but very aggro. i would deff not go further. people cite buffet as an excuse when they want to approach their kellys but day traing is almost always different than long term value investing where you arent really concerned about public opinion in making you decisions, but day traders should mostly focus on public opinion.

also i assume you get that everyone is referring to black swans. yours and most strategies dont take into account the 1-1000 chance of losing 50% on some bet because of a maket frenzy of some sort. i suggest reading a lot of iscouraging stroies then betting around 2%.

does your strategy somehow not show any differences between trades? if you can estimate stronger certainty with some trades than others maybe you can bet 2.5% on you best trade per month, 2% on the next 2, 1.5% on the next 2, and 1% on your least certain trades. then keep a record of how your tades do over a year. maybe you will not even make your least certain trades but can bet 3-4%on your best trades, etc
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Old June 2nd, 2011, 05:36 AM
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blackjack avenger blackjack avenger is offline
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Default I Agree

Quote:
Originally Posted by zengrifter View Post
Cannot accurately apply Kelly UNLESS you know your advantage BEFORE you bet. zg
As one is less certain of their advantage they should be more conservative, as is the case with market trading.

example:
half kelly blackjack bank
3rd or 4th kelly market trading bank

For certainty of growth 4th through 8th kelly is very strong.

Also, should be considered one bank for all games/investments.
  #8  
Old June 2nd, 2011, 05:39 AM
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blackjack avenger blackjack avenger is offline
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Default Like it

Quote:
Originally Posted by blackriver View Post
does your strategy somehow not show any differences between trades? if you can estimate stronger certainty with some trades than others maybe you can bet 2.5% on you best trade per month, 2% on the next 2, 1.5% on the next 2, and 1% on your least certain trades. then keep a record of how your tades do over a year. maybe you will not even make your least certain trades but can bet 3-4%on your best trades, etc
I like this, I think you would have to use models vs real results because in the real world one would have a limited number of trades for comparisons.
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Old June 2nd, 2011, 04:22 PM
matt21 matt21 is offline
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Quote:
Originally Posted by blackjack avenger View Post
As one is less certain of their advantage they should be more conservative, as is the case with market trading.

example:
half kelly blackjack bank
3rd or 4th kelly market trading bank

For certainty of growth 4th through 8th kelly is very strong.

Also, should be considered one bank for all games/investments.
Can you clarify what you mean by "3rd or 4th Kelly" and "4th through 8th Kelly"?

I think your other point is dead on - I consider myself to have one single BR that is used for AP and trading simultaneously.
  #10  
Old June 2nd, 2011, 04:34 PM
MangoJ MangoJ is offline
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I guess he means 1/3 or 1/4 of kelly.

A martingale player claims he has an edge of 1% from his strategy, based on past performance (several hundred "trades"). How much should he bet for kelly betting ?
 

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