How Option Traders Can Use The Kelly Formula To Increase The Rate Of Return Of A Portfolio

The Kelly Formula was developed by John Kelly working at Bell Labs. A popular investor Mohnish Pabrai wrote about it extensively in his book. In fact, he simplified it to:

Edge/ Odds = Portion of capital to be allocated to an investment

Without going into detail as to how the formula works, the resultant figure represents the maximum percentage of capital that can be allocated to one investment. For example, if the number is ⅖ which is essentially 40%, it means that the maximum that one should allocate to that particular investment is 40%.

Do remember that the Kelly Formula is not perfect. It is essentially saying that an options trader should bet more heavily on his best ideas. [ Of course, options traders should still follow strict money management rules and not allow the account balance to fall to 75% to 80% of the beginning account balance]

Let us look at a hypothetical example. A trader has $1000,000 in his trading account. He makes the following trades:

He invests $50,000 into each trade. In total, he invests $100,000 into two trades.

Trade 1 Trade 2
Percentage loss(-) or profit(+) +10% + 100 %
Absolute amount earned(+) or lost(-) +$5000 +$50000

Based on the above, the total amount earned is $55,000.

What is the trader decides to allocate a greater amount to Trade 2 and less to Trade 1 with amounts invested being $70,000 and $30,000 respectively. Do note that the total amount invested is still $100,000.

Trade 1 Trade 2
Percentage loss(-) or profit(+) +10% + 100 %
Absolute amount earned(+) or lost(-) +$3000 +$70000

Now, he has earned a total of:

$70,000 + $3000 = $73,000

As you can see, a greater amount invested into the best ideas can generate a greater return on the portfolio or account balance.

Summary

Do note that the kelly formula is not to be followed strictly. A trader should still rely on sound money management strategies. But rather, it advocates that an options trader should consider allocating more capital to better ideas(ideas with favorable risk.reward ratios) with a greater probability of winning. Over time, this is expected to work in the trader’s favor.

Read:

How Option Traders Can Increase The Winning Percentage Or The Probability Of A Positive Return On Investment

Intelligent money management strategies for option traders

Understanding Risk/Reward Ratio For Option Traders