Kelly Criterion
Kelly criterion is a position sizing rule that suggests how much to risk based on edge and odds, under strong assumptions.
Definition
Kelly criterion is a position sizing method that estimates an optimal fraction of capital to allocate when you have an edge. It is popular because it links size to both your probability estimate and the payoff structure.
Why it matters
In prediction markets, small edges are easy to overestimate. Kelly highlights an important idea: even if you have positive edge, sizing too aggressively can create large drawdowns, especially with fees and execution frictions.
Practical guidance
• Treat Kelly as a theoretical upper bound, not a default.
• Consider fractional Kelly to reduce volatility.
• Always account for bid ask spread, slippage, and trading fee.
• If you are not consistently calibrated, sizing rules amplify mistakes.
Common pitfalls
Edge error: If your predicted probability is wrong, Kelly can recommend dangerously large size.
Ignoring costs: Kelly based on raw price ignores real execution and fees.
Overconfidence: Kelly is most dangerous when combined with overconfidence.