Compounding

Kelly Criterion and How to Size Your Positions

If you have an edge in the market—meaning you know (with some reasonable confidence) that your win rate is higher than random, and your average win is larger than your average loss—the question becomes: how much of your capital should you risk on each trade? Bet too small and you grow capital slowly. Bet too large and a natural losing streak can wipe you out.

The Kelly Criterion is a mathematical formula that answers this question: the fraction of your capital to risk is (win rate × average win) minus (loss rate × average loss), divided by average win. The formula tells you the maximum safe percentage of capital to risk per trade, assuming you have actual historical data on your edge. For a strategy with a 55% win rate and a 1:1 risk-reward ratio, Kelly says to risk about 5% of capital per trade.

Kelly is mathematically optimal in the long run but psychologically brutal in practice—following it exactly means accepting 20-40% drawdowns as normal. Most professional traders use a fraction of Kelly (say, one-quarter to one-half) to smooth out their returns and make them easier to psychologically tolerate.

A simpler rule that many successful traders use: never risk more than 1-2% of your account on a single trade. If your account is 10 lakh rupees and you decide to risk 1%, that means a maximum loss of 10,000 rupees per trade. Once you know your risk per trade, you can calculate position size: if you are willing to lose 10,000 and your stop loss is 50 rupees away from entry, you can buy 200 shares (200 × 50 = 10,000). Position size is not picked arbitrarily; it follows from your risk.

  • Position size should be driven by how much capital you're willing to lose, not by how big a move you expect.
  • A smaller position sized correctly beats a large position sized recklessly.
  • Kelly Criterion gives you the mathematical maximum; most traders should size smaller for psychological comfort.
  • Unknown edge means unknown optimal bet size; in that case, use a conservative fixed percentage (1-2% per trade).