Avoid Investing Too Much or Too Little Using the Kelly Criterion
Money management is perhaps one of the most important aspects of a trader’s success. You will never be 100 percent correct in your trading predictions, and even if you are correct a majority of the time, a poor money management technique can lead you to losing more money than you gain. One of the big advantages of trading binary options is that money management here is much easier than in other types of trade. A skilled trader can use this fact to their advantage and make a lot of money in a safer manner than most other types of trading will allow.
This happens because binary options have a more complete set of information than any other type of trading will offer. You always know how much you stand to lose if you are incorrect and how much you can earn if you are wrong. This knowledge will allow you to better manage your trading and will make sure that you are never risking too much on any given trade.
One easy method of money management is called the Kelly Criterion. This probability theory takes into account your risk and benefits and compares it to your perceived advantage in order to show what percentage of your bankroll you should put at risk. With a big enough bankroll and a good eye for predicting price movement, the Kelly formula will minimize your losses and give you a big advantage over the vast majority of other traders.
The Criterion itself is pretty simple. It involves some math, but it’s basically filling in numbers. This is what it looks like:
Fraction to risk = ((Odds offered x Probability of correct trade) – (Probability of incorrect trade))
If you’re confused by this, don’t worry. It looks much more complex than it actually is. Let’s plug in some numbers.
Assume you want to trade oil, and your broker is giving you an 82 percentrate of return. Further assume that you’ve been trading for quite a while, and you have estimated your correct trade rate at 64 percent. This is now what it looks like:
Fraction to risk =((.82 x .64) – (.18))/(.82)
The above equation states that your fraction to risk is 0.42 percent. If you are starting out with $10,000, this means you should risk $42 on this specific trade. The purpose of Kelly’s formula is to minimize risk and exploit your edge. You will find that the bigger your advantage—whether it be the return being offered or your probability of success or both—the more you will want to risk. The smaller these factors are for you, the less you should risk. You might even find that at some points it is smart to not even execute a trade. The Kelly formula will let you know when this is the case by giving you a negative number.
This formula illustrates two important points. One, it shows you that if you want to be successful, you need to set aside quite a bit of money. If you are trading in $40 increments most of the time, you will want a bankroll of $10,000 or more to start out with.
The other point is more important. It implies that most people risk too much on small edges. If you have a small edge, you should risk a small amount. When your edge gets bigger, you should risk more, but you still need to risk only a small amount. The point of Kelly is to make sure that you never go broke. The better you are at determining your correct trade rate at any given time, the closer you will be to this goal.