Investing in stocks using the Kelly criterion money management strategy

In order to reduce your investment risk you have to diversify. The problem is that many traders do not know how to put the diversification concept into practice. How do we know the number of stocks to invest in and the percentage of equity to put in each one of these stocks? When to invest in more stocks and when to reduce our exposure?

The Kelly criterion attempts to provide an answer to all these questions. This money management strategy is based on two concepts, which are the Winner probability (Probability of a given trade to provide a positive return) and the Win/Loss ratio (The percentage of winners among all trades).

John Kelly, the developer of the Kelly criterion technique used these two ratios to create what is called the Kelly percentage. It is a value, expressed in percentage, which tells us how much we should invest in each stock.

Depending on the performance of past trades, Kelly criterion may tell us to invest all our money in three stocks or it may tell us to invest in more than 20 stocks (investing in highly diversified portfolio).

The money management script, based on the Kelly criterion technique, I have developed here allows you to specify two inputs.

The number of past trades: This is the total number of past trades the money management will use to calculate the Kelly percentage value. A value of 0.5 indicates that we should invest 50% of our equity in a single stock and therefore our portfolio will be composed of only two stocks.

The maximum number of positions: This is the maximum number of positions we should hold in a given period. If the Kelly percentage returns a value of 1% (This means that we should invest in 100 stocks) and the maximum positions is set to 50, then our trading system will invest in only 50 stocks. This prevents us from investing in portfolios that are too diversified.

Using the Kelly criterion strategy is very simple. After you download the current script, here are the different steps that should be performed:

- Update a trading system

- Select the Money Management tab

- Click on Add an existing money management script

- Select the Kelly criterion item

This script generates also a metric called Kelly % that returns the Kelly percentage value over time.

You can display this metric by dragging it from the Select a time-series list in the simulation report then dropping it into the strategy equity chart.

Other useful money management script: