Online Stock Trading Tips

One of the most effective ways to invest money in stocks is to use Kelly Criterion. The objective of Kelly criterion is to let you know how much you should invest in each equities of your highly diversified stocks portfolio to maximize the capital growth. In short, %Kelly is the percentage in your total equity of which you will need to invest in each of those securities. For example if Kelly percentage is 5%, it says that you need to invest 5% capital to each of your equities.

If 100% represents the total equity, then with 5% it is possible to invest in around (100/5) = 20 highly diversified stocks. This % will guarantee the maximum growth of investment. Interesting isn’t it?

Let’s take a look at the Kelly criterion formula:

Kelly percentage = Winning Probability – [(1 – Winning Probability) / WL]

Where:

Winning Probability = probability of winning trades. If you already made a total of 200 trades in the past and around 105 are winning trades. The Winning probability is:

Winning Probability = 105/200 = 0.525
Experts in Kelly criterion suggest that greater 0.5 is acceptable. Although by rules of expectancy, savvy trader with proper money management can even earn profits with winning probabilities less than 0.5.

WL = Win/Loss ratio, this is the ratio of the average win in dollars (or in your own trading currency) over average loss in dollars. For example in your trading history of 200 trades, your entire win (the 105 winning trades) averages $200 per winning trade while your losses average $100.

The Win/Loss ratio in this example is = $200/$100 = 2

Therefore the Kelly percentage = (0.525) – [(1-0.525)/2]

Kelly percentage = (0.525) – (0.2375) = 0.2875 or 28.75%

In this way, you can trade up to = 100%/28.75% =3.4, 3 stocks in your portfolio and share it around 28.75% each. What if before you trade more than 3 stocks? Of course select the top 3 best performing stocks in terms of average win and %win probabilities it will give your best chances.

What is the important requirement of the Kelly Criterion? It is important to take note that not all trading systems are feasible to be implemented with Kelly Criterion. One of the most important requirements before you implement Kelly Criterion is that your trading system should have POSITIVE EXPECTANCY. This means that it is proven it can make profits.

The formula for expectancy is: Expectancy = (Probability of Win * Average Win) – (Probability of Loss * Average Loss)

If expectancy is less than 1, then the odds are against you, you should NOT trade using that system or you should not trade using Kelly Criterion or else you will lose your entire trading capital.

In the above example, the expectancy: (0.525*200) – (0.475* 100) = $57.5 average profit per trade.

What if the trading system currently produces “positive expectancy”?

Then gather statistics of at least 100 to 200 trades (the higher the sample size, the better as it produces more accurate results). If you cannot obtain that using real trading, you might as well do some paper trading. Read this tutorial on how to paper trade stocks?

The more accurate and more serious you are in gathering those statistics, the higher your chances of successfully integrating Kelly Criterion in your trading system.

Related posts:

1. Stock Exit Strategy: Formulating an Effective Profit Targets
2. How to make Trading a lifetime career?
3. The Principles of Money Management in Stock Trading
4. Investing with Little Money: Ideas, Tricks and Tips

This entry was posted on Tuesday, March 16th, 2010 at 4:59 pm and is filed under Money Management. You can follow any responses to this entry through the RSS 2.0 feed. You can skip to the end and leave a response. Pinging is currently not allowed.