The Kelly Criterion is a mathematical formula that calculates the optimal percentage of capital to risk on each trade to maximize the long-term geometric growth rate of a portfolio. Developed by John L. Kelly Jr. in 1956, it determines the ideal bet size based on the probability of winning and the payoff ratio, balancing the trade-off between growth and risk.
The Kelly Criterion formula for trading is: Kelly % = W - [(1 - W) / R], where W is the win rate (as a decimal) and R is the average win/average loss ratio. For example, with a 55% win rate and a 1.5:1 reward-to-risk ratio, Kelly % = 0.55 - (0.45 / 1.5) = 0.55 - 0.30 = 0.25, or 25% of capital per trade. In practice, most traders use a fraction of the Kelly percentage (typically half-Kelly or quarter-Kelly) because the full Kelly amount produces large equity swings that are psychologically and practically difficult to handle. A negative Kelly value means the strategy has no edge and should not be traded.
A trader's strategy has a 48% win rate with an average win of $600 and an average loss of $300 (R = 2.0). Kelly % = 0.48 - (0.52 / 2.0) = 0.48 - 0.26 = 0.22, or 22% per trade. This is extremely aggressive. Using half-Kelly (11%) or quarter-Kelly (5.5%) reduces volatility significantly while still capturing most of the growth. At quarter-Kelly, the trader risks 5.5% of their $20,000 account ($1,100) per trade.
The Kelly Criterion provides a mathematically optimal answer to the question every trader faces: how much should I risk per trade? Risking too little leaves money on the table; risking too much increases the probability of ruin. While full Kelly is rarely used in practice due to its aggressive nature, fractional Kelly (especially half-Kelly) offers an excellent balance between growth rate and drawdown management. Understanding Kelly helps traders move from arbitrary risk levels (like always risking 1%) to risk levels based on their actual edge.