Happy Friday.
In the mailbag this week, I received an excellent question about a formula for position sizing…
My question is whether you have ever calculated the Kelly ratio or Kelly criterion factor for your trading? I would like to be able to use the Kelly calculation as a guide to my position sizing when using your recommendations.
– Leo
Hi Leo, thanks for your question.
Proper position sizing is an important element in any trading strategy, especially a strategy that involves options.
Options are designed to reduce risk. Folks who take on too large a position actually do the opposite. So, I’m glad you asked this question.
I’ve previously covered what I think is an ideal portfolio strategy for my recommendations. But most strategies that emphasize limiting position size would be appropriate.
Unfortunately, the Kelly criterion does not do this.
The Kelly criterion is used by a lot of professional gamblers – especially blackjack players and folks betting on horses – as a strategy of using the odds to determine the size of their bets.
Now, at the risk of comparing trading to gambling (which is not an accurate comparison – but that’s a subject for another day), if you can calculate the odds of a trade being profitable and by how much, then you can apply the Kelly criterion to a portfolio strategy – in theory.
In order to do this, you have to have a track record. You have to have a history of trades that you can use to determine certain probabilities. The more history you have, the more accurate the formula will be.
The Kelly criterion formula basically uses a trader’s winning percentage and the profitability of those trades to determine what percentage of a portfolio a trader should allocate to any one trade.
The problem with this is that if you have a high winning percentage, and if the average return on the losing trades is not much greater than the average return on the winning trades, then the Kelly criterion is going to suggest a much larger position than common sense would allow.
For example, in my Delta Report newsletter, so far this year we’ve closed 56 total trades (this includes trades I’ve recommended in the Delta Direct blog as well as official Delta Report recommendations). Forty-five of those 56 trades closed for profits. We lost money on 11 trades. That’s an 80% win rate.
Since we trade options, the average returns are quite large. The average gain on the 45 winning trades was nearly 40% (with an average holding period of less than three weeks). The average loss on the 11 losing trades was about 55%.
So, in simple terms, my next trade recommendation should have an 80% probability of making 40% and a 20% probability of losing 55%. Those are excellent odds. And the Kelly criterion would suggest allocating 48% of one’s portfolio to the next trade.
That’s just stupid.
I understand the math. Since the probability of a winning trade is so high, the Kelly criterion is willing to risk a large percentage of one’s bankroll on the next trade. That makes sense if we were at a blackjack table in Reno.
But I suspect most folks allocate a much smaller percentage of their net worth to “casino night” and a much larger percentage to their investment portfolios. There is no justification for putting 48% of your investment account to any one trade.
So… put the Kelly formula aside. It really isn’t an appropriate portfolio strategy for my recommendations. Instead, stick with what I wrote about here…
Best regards and good trading,
Jeff Clark
P.S. If you have a question about option trading, the state of the market, or anything else discussed in the Market Minute, send me an email right here.
Reader Mailbag
Yesterday, we asked readers if they planned to trade one of gold’s numerous bullish signals.
But first…
I am seeing errors in both the Market Minute as well as in Delta Direct. I believe the S&P 500 traded as low as $2545, not the “$2445” posted.
– Gary
Editor’s note: Kudos for catching that slip of the finger, Gary. We certainly did mean to use the figure you supplied. The error is now fixed.
Now, to readers’ thoughts on bullish gold and retail trades…
Yes, and I'll comment on why I follow you so closely…
You feel no compulsion to come up with a trade every Monday or Tuesday morning… but rather study the market for the best risk/reward situations to act upon. In my opinion, that's a very admirable trait.
Perhaps that means being quiet for three to four weeks running. So be it. I'd rather you waited months if it meant getting it right.
Also, I GREATLY appreciate the additional effort at explaining your reasoning on setting up a trade with your comments on the MACD “circles” with respect to the gold market in the recent Market Minute. Very worthwhile.
A request… if it's possible… to recommend an alternative trade when recommending selling a naked option which, while not being as advantageous, would still provide an opportunity for profit.
Thank you for your work…
– Steve
It was painful from July 2016 to now with my gold position. I have excellent picks from Casey and Agora, but my entry point was very wrong (in the short- to mid-term)… I’d better listen to Steve Sjuggerud!
Now I can better see the cycle in these ultra-volatile stocks! And I have more confidence to hedge me into these mini-cycles…
I’ve done well in recent years, buying low and selling during this uptrend… now I’ll increase my buy-in. Great job, Jeff.
– Fabien
I appreciate your analysis and the straightforward way you apply it to gold. Financial markets seem in turmoil, as if a sea change may be approaching. If so, gold is more likely than not to be in play.
Do you think the price development of rhodium is telling us something? It’s an intriguing commodity and its price history reflects it. An ounce traded as high as $10,000 before the price imploded to well under $1,000 some years ago. There – around $700 – it languished for a decade with surprisingly little volatility, especially considering the dramatic history.
Lately, the price of rhodium has been rising steadily. From half of the price of an ounce of gold, it has risen ever closer to the price of a full ounce of gold during this year.
The rhodium market is small. Rhodium can be an effective catalyst in industrial chemistry. If somebody were buying it up for that purpose, one would hardly expect to hear much about it.
– Goetz
Rickards is screaming about gold. But holding bullion is not the way to go. NAK and PVG screaming already. Huge, huge gains off their lows.
– Patrick
I bought two weeks ago. I hope your “crystal ball” is correct!
– Michael
[Amazon cannot] 100% replace retail, but retail could be depressed further until the weak guys, such as Sears, JCPenney, and many more are closed out. Only strong guys such as Macy’s could survive if they take up methods similar to Amazon.
– Youngkeun
Hi, I haven't heard anything from you recently re: TEVA… I'm still holding this stock and not liking what I'm seeing or the loss I'm sitting on. Your strategy please?
– Tony
Thanks for your note, Tony. You can find Jeff’s latest guidance on TEVA right here…