Hi. This is my first post and I'm a newbie to the world of trading as well. I have a theoretical question perhaps someone can give me some insight into. Are there any good algorithms or just thoughts from experienced traders on the board for determining the correct trade size given varying amounts of risk? I'm not exactly sure how to quantify risk here, but for argument's sake, let's say a trade has a 70% chance of doubling and 30% chance of going down to 0. Assuming you only get a setup like this a finite number of times per year (let's assume it's 5 times), and there are no volume constraints on the trade, how much of your total trading net-worth would you put on the line for each trade? Let's assume that you are not a trader and will not be able to put your money in the stock market for other trades in your lifetime (I'm just trying to isolate the problem) Is there an optimal approach to a problem like this? It's been a long time since I've studied probability and I'm not quite sure how to tackle the problem. Thanks! SH
(1) Look up "Kelly Formula" in Google or Wikipedia. (2) You have a 70% chance of earning 100% AND a 30% chance of losing 100%.....?......your "edge", your optimal betting size, I believe is equal to 40% of your capital.
Yes there is an approach. It's called the Spearhead Sleeps At Night risk level. Easily calculated: Take positions say at 1 % risk. Lose a whole bunch of times. If you can still sleep at night then increase the risk, perhaps try 2 %. If you find you can not sleep then decrease risk, maybe to 0.5 %. In your spare time you can read math books and learn all that nifty probability stuff.
You will never know the probability of future outcomes with such numeric precision. Assuming that you can is your greatest risk. As for formulas/algorithms that attempt to capitalize on such probabilistic specificity, consider the definition of a calculator: an instrument that allows you to take two seat-of-the-pants estimates, multiply them, and get accuracy to the 8th decimal.
Hello Spearhead: After 41 years of "The Market" I'd say that the reply from each of the first 3 were Right On. Print them and paste on the side of your monitor. agpilot
Thanks for the replies. The Kelly formula was basically what I was looking for. I do realize that it's impossible to calculate risk, but the question would've been difficult to ask otherwise since I'm trying to factor out psychology and get something theoretically correct.
If you think that the Kelly formula will help you in your trading, then I think you are mistaken. Try a few hypothetical values using the formula and see what kind of bet size it will give you: http://en.wikipedia.org/wiki/Kelly_criterion Would you even consider risking anywhere near that amount on any given trade? And that presupposes the validity of your assumed probabilities, whereas trading is not quite as elegant as a true mathematical game of chance with known probabilities.
go to a poker game with $40 on the 1/2 no limit holdem tables at your local casino. Youll discover the lesson you need to learn. It'll be cheap compared to the alternative.
I know your response was just meant to illustrate the point of not being to practically use the formula to make real bets on the market. However, I don't think this really applies to poker, at least at a $40 buy-in table. I can't think of too many people who wouldn't call an all-in bet regardless of stack size if they were even 60% sure they had the better hand. If I had my entire net-worth on the line, I might not call the bet. But I think the Kelly formula (or maybe some modified version of it) would apply here.