Determining Optimal Capital Allocation in Trading
The optimal capital allocation in trading is most likely not very well understood by most traders. The balance between attack and defense is often a thin line. Most of us are optimists and we rarely watch out below. It’s human nature – pessimists never won any wars! What is the optimal capital allocation in trading?
You can calculate the optimal capital allocation in trading by using two very simple formulas: the Kelly Criterion and a formula provided by Wolf von Rönik.
They are both theoretical values, of course, but they provide you with estimates but foremost an understanding of how you can better balance attack and defense in trading.
Before we go on to calculate the optimal capital allocation in trading, let’s briefly discuss the most important factors in trading:
What is most important in trading?
The most important thing in trading is having a trading edge. In a former article, we asked the following: is focusing on psychology overrated in trading? We still believe it is and the assumption is correct. However, trading is mainly about three things:
- Having a trading edge.
- Know yourself and your limit. You need a trader’s mindset.
- You need proper risk management.
The first bullet point is by far the most important one, but this article is mainly about the third point. Avoiding big drawdowns and the risk of ruin in trading is very important. To balance that you need to have some ideas of what is the best allocation of your capital.
First, let’s define what we mean by risk in trading.
What is risk in trading?
We define risk as the chances or probability that you will suffer losses that force you to stop or be unable to recover from a financial loss. It doesn’t necessarily mean that you lose “everything”.
Our experience is that very few traders and investors have what it takes to go through a severe drawdown in trading. When the drawdown exceeds 20% many simply stop trading or make substantial changes to their strategies.
They start fiddling with their strategies and in reality abandon them. What looks so easy in backtesting is not as easy in the midst of a drawdown.
Why do you want to minimize risk in trading?
If you lose 50% of your capital you need to make 100% to recover. If you lose 75% you need to make 400%. The math makes it pretty easy to see why you want to avoid any substantial losses.
With that in mind let’s go on to look at the optimal capital allocation in trading:
What Is The Optimal Capital Allocation In Trading?
Let’s start by explaining the Kelly Criterion:
What is the Kelly Criterion?
The mathematician John Kelly made a formula in 1956 that looked at the optimal betting size when the expected returns are known.
The whole idea with the Kelly Criterion is that you need to understand the difference between arithmetic and geometric averages. The Kelly Criterion is based on the expected geometric return and not the arithmetic average. It maximizes the expected value by considering the risk of ruin and losses. To better understand the Kelly Criterion we also recommend one of our older articles about linear vs logari