It is widely acknowledged nowadays that cryptocurrency trading stands as one of the most fast-paced and potentially lucrative areas of in the world of investing. However, like any form of investing, it is not without its perils. A huge number of traders strive to find the best money management strategies possible to maximize their profits and thus minimize risks. One such method is called the Kelly criterion.
What exactly is Kelly criterion betting?
Such way of betting, named after its creator, John L. Kelly Jr., is a mathematical formula for optimal bet sizing which requires considering information about odds of success and return-to-risk ratios. This formula indicates the ideal percentage of capital to bet in order to maximize the growth rate over the long run.
So how to employ Kelly Criterion in crypto trading?
One of the key aspects of using this strategy is to assess the likelihood of a successful transaction. This can be done using technical and fundamental analysis as well as by keeping track of a market dynamic. That is, the more accurately you estimate the odds of a successful outcome, the more precisely you are able to apply the Kelly criterion.
For crypto trading specifically, as with any other investment asset, it is essential to determine the potential returns and all the likely losses in case of failure. This will allow you to identify the risk/reward ratio, which in turn is used in the Kelly formula.
After evaluating these parameters, you can apply Kelly criterion to figure out the optimum stake.
Case 1: Estimating winning probabilities
Let’s say you use a crypto data analytics tool that displays the following: there is a 70% chance that the price of Bitcoin will climb by 5% in the next 24 hours, based on historical data and technical analysis. This implies that according to your analysis, the trade has a 70% winning probability.
Case 2: Estimating the return-to-risk ratio
Imagine you are analyzing the ETH/USD trading pair and determining that your potential profit is 20% out of investments you made. So should the value of Ethereum rally, your losing probability equals 10% assuming an unfavorable outcome. This gives you a 2:1 return-to-risk ratio.
Case 3: Applying captured data to Kelly сriterion
With the resulting data collected from Cases 1 and 2, you are free to make a decision on the betting size without applying the Kelly formula directly. For instance, if you have $1,000 and your trade has a 70% winning probability and a 2:1 return-to-risk ratio, you may decide to risk 20% of your capital on that trade.
Therefore, understanding the winning/losing probability and the return-to-risk ratio empowers traders to make more informed betting decisions and effectively manage their funds in an extremely volatile crypto market.
How relevant is the use of the such trading strategy in trading crypto?
Using the Kelly criterion when trading cryptocurrency may be a good option in certain situations, but requires a cautious and informed approach. There are a few considerations to be weighed:
- High volatility. The cryptocurrency market is known for its ever-dynamic price swings. This can make estimating the abovementioned parameters more challenging, which can reduce the performance of trading according to Kelly criterion.
- Limited historical data. The crypto market is relatively young, so historical data may be limited in a way. As a result, it’s more difficult to accurately estimate the winning probability so it may affect the outcomes of using the strategy.
- Imbalance of fundamentals. Fundamental factors affecting the price of any given crypto, such as regulation, technological developments and market sentiment – all these can change dramatically and unexpectedly. This can make predicting price movement more challenging and elevate possible risks.
- Psychologic aspects. The Kelly criterion strategy entails strict discipline and confidence in one’s evaluations. However, crypto market can be subject to frequent trend rollercoasters, which can make it difficult to follow Kelly’s strategy.
- Diversification. Cryptocurrencies can be sensitive to certain factors such as recent security news, regulatory policies or announced updates. Such thing as diversification can be beneficial in reducing risk and increasing the stability of your investment portfolio.
While the Kelly’s method can be a useful tool for money management in crypto trading, its effectiveness can be highly dependent on specific market conditions and a trader’s ability to accurately assess the winning probability and return-to-risk ratio. Traders should use Kelly criterion betting in combination with other strategies and take into account the specific features of crypto markets when making decisions.
Comparing the Kelly criterion with other models
There exist plenty of money management techniques when trading crypto, each with its own perks and lows. As such, here we compare the Kelly criterion to several other trading strategies:
Kelly criterion vs Fixed bet size strategy:
Kelly criterion: as said above, this one determines the optimal bet size based on an estimate of the winning probability and the return-to-risk ratio. This maximizes capital growth over the long term while also minimizing risk.
Fixed bet size strategy: here traders risk the one and the same percentage of their capital on each trade. This provides stability, but can lead to underinvestment in potentially successful trades or rather severe losses.
Kelly criterion vs Martingale betting system:
Kelly criterion: optimizes bet size by taking into account the probability of success and the return-to-risk ratio. This is based on the principles of expected return and risk minimization.
Martingale betting system: here a trader doubles the size of his next bet after each unsuccessful trade in order to make up for previous losses. This can lead to a long series of significant failures.
Kelly criterion vs fixed income method:
Kelly Method: once again to make it clear – this one optimizes bet size based on the probability of success and the return-to-risk ratio, which can lead to maximizing profit while minimizing risk.
Fixed income method: traders set a fixed percentage of profit that they seek to obtain from each trade. This may seem a more conservative approach, but does not take into account market conditions.
Conclusion
Using Kelly criterion in crypto trading can help traders handle their capital wisely and boost expected profits while mitigating risks. However, keep in mind that the Kelly criterion is not a one-size-fits-all solution so it should be used considering other factors such as individual preferences, market conditions, as well as the degree of confidence in winning probability and return estimates.