The market can stay irrational much longer than you can stay solvent

(John Maynard Keynes)

Id be a bum on the street with a tin cu i! the markets were always
e!!icient ("arren #u!!ett)
$%&'() *' +),%- ./0'12 3'4'56/ (75%893',9 :65%;%*9)
<=>?@ by Aasily Bekrasov
IF#B HEIJKJ>>J>@LM=>JI
httNOOwwwDyetanotherPuantDcom
=
Contents
Qre!ace DDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDD K
Rhater ?N S brie! review o! the robability theory DDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDD L
Rhater =N Money Management according to Kelly criterionN the !irst
encounter DDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDD =>
Rhater KN More on T- robability- dri!t and volatility DDDDDDDDDDDDDDDDDDDDDDDDDD K?
Rhater @N #acktesting DDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDD EH
Rhater MN Multivariate ort!olios DDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDD HI
Rhater LN Qricing and trading derivatives DDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDD ?=E
Rhater EN Qsychology- time management- technical ePuiment and
other asects o! ractical trading DDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDD ?@@
K
Preface
There are thousands o! books on trading
?
D Uor instance- the Puery
VtradingV yielded (on >@D>=D=>?@) L=HIL results on amaWonDcomD
Cowever- the content is eXtremely reetitive !rom book to bookD Uirst o!
all most o! them sell hoe- not knowledgeD It is actually obviousN a
ro!essional writer (ro!essional in the sense that he writes !or a living)
wants his books to be soldD It is much easier to sell hoe than knowledge
(which is o!ten bitter) to a mass readerD Fuch books usually tell you that
there are several markets (ePuities- commodities- bonds- UY) and either
one o! these markets is claimed to suit a rivate trader articularly well or
it is recommended to concentrate on ro!it oortunities- not on asset
classesD Then comes a common warning that Vmost time the markets are
unredictableV- or alternatively an encouragement that the stock rices
grow in the long termD Then some very basic in!ormation on brokers and
trading orders- robably something on !undamental analysis and market
sychologyD Most o! these books are about technical analysis such as
chart atterns- since the Puantitative indicators like moving averages
rePuire some mathematics- which the most o! mass readers do not
ossessD
Ss to concrete trading strategy recommendations- they are distinctly
clustered (and sorted in order o! the cluster siWe) as !ollowsN nothing
concrete- trend !ollowing- swing trading- buy and hold- airOsread
trading and VeXoticsV like seasonal trading and chasing enny stocksD "ith
very !ew eXcetions no book contains a detailed strategy descritionD #ut
even i! the latter is there- there is still no word about the backtestingD
Money management is either comletely disregarded or its imortance is
noted but without detailed argumentsD Roncrete recommendations are
rare- the rules o! thumb are to not risk more than XZ o! the caital er
trade (XZ is o!ten ?Z or =Z- sometimes u to MZ)D Snother common
advice is to take the volatility into account but all they recommend is
usually [ust to take smaller ositions in volatile stocksD
\n the other hand there are a lot o! books on VmodernV Puantitative
!inanceD "hile the most o! them are mathematically !lawless- their
content is both unreadable !or a mere mortal and has little to do with
?
In this book the words VinvestmentV and VtradingV are used interchangeablyD
@
realityD Snd o! course they are very costly] ^?>>_ is not an uncommon
riceD
In this sense this book is brand newD Uirst o! all- it does not sell
hoe and is not intended !or VdummiesVD Tather it is !or retail investors
who already have some eXerienceD It is also very use!ul !or students who
study `Puantitativea !inanceD In order to read this book- you need a
working knowledge o! college mathematics
=
D \n the other hand- this book
is ractically oriented and comletely void o! mathematical arroganceD
Moreover- the content o! the chaters = and K is very elementary but at
the same time thoroughly eXlainedD bven i! you coe only with these
chaters- the book is worth its rice since you get a clear ercetion o!
what you can (and what you cannot) achieve in the market in the long
termD
Modern investment is unthinkable without modern IT- so some
rogramming skills are very hel!ul (though not necessary i! you are ready
to learn in arallel)D
This book does not resent any out o! boX suer winning strategy (though
I do disclose my ersonal investment aroach)D Fuch strategies J even i!
they do work J eXire PuicklyD Cowever- this book does rovide you with a
toolset to create (and what is more imortant- to test and evaluate)
trading strategiesD
I also take into account that (like me) the most o! my readers have a
!ulltime [ob and a !amilyD This imlies that a practical investment activity
should not be too timeJconsumingD Uor those- who are too busy and have
very little time but still wish to invest this book rovides some hints how
to avoid common errors and it!allsD
Fince I live in Germany- I mostly watch the German marketD Thus most o!
the eXamles are about German stocksD Though the German market does
have its eculiarities (strong deendence on eXort- conservatism o!
German investors)- these eXamles are straight!orwardly alicable !or
any develoed marketD
=
I mean cF college level- which is aroXimately ePual to the German Sbitur or
Tussian highJschool with emhasis on mathD
M
Uinally- it is worth eXlaining what motivated me to write this bookD "ell-
!irst o! all when a man has anything to tell in this world- the di!!iculty is
not to make him tell it- but to revent him !rom telling itV
K
D dike every
erson I also want my e!!orts to be rewardedD Cowever- I eXect the main
ro!it not !rom the book sales but rather !rom the increase in my
goodwillN being an author o! a good book usually hels in careerD Keeing
the book rice under e?M I try to make it a!!ordable !or everyone and in
articular !or studentsD I hoe this book will be interesting and use!ul to
the readers and hel to navigate in turbulent !inancial marketsD
"riting a book is always a big undertaking- which rePuires a lot o! time
and concentrationD This book would never be written without my wi!e
\les[a who insired and suorted me all the timeD Karla Qenter did her
best to translate my Tussian bnglish to the #ritish bnglish (all remained
tyos and grammar mistakes are comletely my !ault- not hers)D I am very
indebted to frD Thomas Tu !or his valuable remarksD
In order to imrove the book I actively used crowd!olksourcingD I am
grate!ul to everybody who has contributed- in articular to Matthias
Fiemering- Jgrg Ciermayr- fimitri Femenchenko- fmitriy #ogdanis- frD
Urank "ittemann- frD Qeter Fchwendner- frD Toland Ftamm- frD Sleksey
Min- Batalia Fhenkman- Ftanislav Barivonchik- SleX \cnariu- SleXander
Mora Sraya- faniel damarter- faniel Fchroeter- blena Tichi[- Ulorin deist-
UranWiska herweck- Gloria Ftraub- daila cnkau!- \ksana Mook- Toman
"enger- Fekou Rissi- Rhristiane Kandeler- Reline de Fousa and AincenWo
de MatteoD
K
Raesar and Rleoatra by George #ernard Fhaw
(httNOOwwwDgutenbergDorgO!ilesOKK=HOKK=HJhOKK=HJhDhtmjlink=Ck@k>>>K)D
L
Chapter 1: A brief review of the probability theory
Ss I warned you- you need a working knowledge o! college
mathematics in order to read this bookD Uor the sake o!
comleteness- we brie!ly review the main ideas o! the robability
theoryD "e start with a PuiW- which although elementary is not
trivialD Moreover- it addresses both the tyical roblems you will
encounter as an investor and some !ine ideas o! robability theory
that o!ten remain beyond the scoe o! the !irst course on
robabilityD I! the PuiW is no roblem !or you then neither will be the
rest o! the bookD #ut i! you cannot comrehend it even a!ter
reading the solutions thenDDD well- you might still succeed as
investorD I know a coule o! eole that have trouble with this PuiW
but are still success!ul on the market (or at least they say that they
are)D Cowever- I believe the investment should be a healthy blend
o! science and li!e eXerience rather than a curios miXture o!
subconsciousness and voodoo cra!tD
Q1: Initial rices o! stocks S and # were- resectively- ^?> and ^?>>D
dater the rices grew- resectively- to ^=> and ^?M>D "hich stock
er!ormed betterl
Q2: S ort!olio consists o! three stocks] their weights in ort!olio
are ePualD S!ter a year the !irst stock yielded ?MZ- the second
J=>Z and the third one ?>ZD "hat is ort!olioms total returnl
Q3: S trader invested his caital in an bTU
@
on TTF
M
D The return !or
the !irst year was ?>Z- !or the second year ?MZ but !or the third
year J=>ZD S!ter the third year a trader sold his ort!olioD Cow much
has he earnedl
Q4: S similar situation as by nK but now the returns were
J=>Z- ?MZ and ?>ZD foes the order o! returns really matterl
@
bXchange Traded Uund
M
Tussian stock indeX
E
Q5: S stock droed by x% then grew by y% and returned to its
initial riceD "rite a !ormula to eXress y via xD
Q6: S trader bought a stock- held it !or three months and then sold-
yielding MZD "hat is his annualiWed growth ratel
Q7: I! we want to double our wealth in !ive years- which annualiWed
growth rate do we needl
Q8: \ne thousand eole took a new medicineD \ne o! them had
an allergic reactionD "hat is the robability o! the allergic resonsel
Q9: S deck consists o! KL cards
L
D "hat are the robabilities a) to get
a Pueen- b) to get sades- c) to get the Pueen o! sadesl
Q10: \ne has tossed a coin ten times and got ten headsD "hat is
the robability to get a head by the eleventh tossl
Q11: The !irst bank account ays LZ annually- the second ays KZ
semiJannually- the third ays ?DMZ Puarterly and the !ourth ays
>DMZ monthlyD "hich bank account is better (assuming they all can
be considered riskJ!ree)l
L
Fuch VabridgedV decks are most common in TussiaD There are H values !rom siX
to ace and @ suitsD
I
A1: The return on the !irst stock is (=>J?>)O?> o ? o ?>>Z- whereas
the return on the second stock is (?M>J?>>)O?>> o >DM o M>ZD Thus
the !irst stock has er!ormed betterD The absolute rice changes (in
this case- resectively- ^?> and ^M>) do not matterN i! an investor
has- eDgD ^?>>- he can buy either ten stocks S or one stock #D In the
!irst case his gain will be ?>p^?> o ^?>> and in the second case [ust
?p^M>o^M>D
A2: Sssume a trader initially had x dollarsD The stock weights in
ort!olio are ePual- iDeD he has invested x/3 dollars in each stockD Cis
terminal wealth is then (?_>D?M)x/3 + (?J>D=)x/3 _ (?_>D?)x/3 o (K _
>D>M)x/3 o x _ >D>?LExD Fince his initial caital was x- the total return
is ePual to (x _ >D>?LEx - x) / x = 0.0167. \! course we could [ust
have calculated the `simlea average o! returnsN (>D?M J >D= _ >D?) O K
o >D>?LE o ?DLEZD In general- the weights o! stocks in a ort!olio are
not the sameD In this case the ort!olio return is ePual to
n
P
i=1
w
i
r
i
=
n
P
i=1
w
i
- where w
i
and r
i
are the weight and the return o! the
i-th stockD
A3: Sssume a trader initially had x dollarsD S!ter the !irst year the
return was ?>Z- so the total wealth a!ter the !irst year is
x + 0.1x =x(1+0.1)= 1.1x . The return !or the second year was ?MZ
and a trader had 1.1x dollars at the beginning o! the second yearD
That is- his wealth at the end o! the second year is 1.1x(1+0.15) =
1.65x D Snalogously- the wealth at the end o! the third year is
1.65x(1-0.) = 1.01x D Fo the total return is ?D=ZD Snd the
ann!ali"#d return (sD SL) is [ust >D@ZD The lesson !rom n= and nKN
never con!use an arithmetic mean and a comound annual growth
rate (RSGT)D
A4N Ss you likely noticed- the !ormula to calculate the total return
!or the case o! nK is (?_>D?)(?_>D?M)(?J>D=) J ? D Fince the roduct is
commutative- the order o! annual returns does not matterD
Cowever- it likely matters !rom a sychological oint o! viewN
esecially !or a newbie the scenario J=>Z- ?MZ- ?>Z is much less
com!ortable than ?>Z- ?MZ- J=>ZD Ss a matter o! !act- most o!
trading so!tware dislays only the acPuisition rice and the current
H

riceD Fo in the !irst case a trader will always see a ro!itD Though
the ro!it decreases !rom =LDMZ to ?D=Z- comaring the acPuisition
rice with the current rice we are still in the blackD #ut in the
second case we !irst need to endure the loss o! =>ZD Bote that the
eXerienced traders usually consider the $axi$!$ drawdown-
which does not deend on the order o! returns and is ePual to J=>Z
in both casesD Uurther we will use the maXimum drawdown as the
main measure o! riskD
A5: It holdsN ? o (?Jx)(?_y) thus y =
1
1 x
1
det us calculate some concrete values- which you should learn by
heartN
-x y

J?D>>Z ?D>?Z
JMD>>Z MD=LZ
J?>D>>Z ??D??Z
J?MD>>Z ?EDLMZ
J=>D>>Z =MD>>Z
J=MD>>Z KKDKKZ
JKKDKKZ M>D>>Z
JM>D>>Z ?>>D>>Z
JL>D>>Z ?M>D>>Z
JE>D>>Z =KKDKKZ

A6: The Puestion is not as elementary as it may seem to beD Uirst o!
all- the answer deends on the soJcalled day count conventionD The
simlest one is K>OKL>- iDeD !or simlicityms sake we assume K> days
in every month and KL> days in every yearD Thus `anya three months
make eXactly a Puarter o! year and it holdsN (1 +r)
0:25
= 1:05
Taking logs we obtain 0:25 ln(1 +r) = ln(1:05) = 0:04879
bXonentiate and get 1 +r = exp(0:19516) = 1:21550
Uinally r = 0:21550 "e check the solutionN
(1 +0:21550)
0:25
= 1:04999865 1:05
?>

The general !ormula ?JSLJ? is not the only !easible one (sD S??)D
Cowever- it is most common in `racticala !inanceD
(1 + r)
t
= 1 + R
r = exp

ln(1 + R)
t

1
Formula 1-A6-1 RSGT or the annualiWation o! the
interest rate % accrued during the time tD

Bote that the MZ that was yielded a!ter the three months are called
`Puarterlya &i$pl# r#t!rn. The average (or the arithmetic mean) o! the
simle returns over several eriods is called arith$#tic r#t!rnD The
arithmetic return is an imortant number !or a series o! bets (or trades)
witho!t reinvestment o! winningsD It is also used to !ind the otimal
ort!olios (sD the chater on Kelly criterion)D #ut in order to characteriWe a
series o! trades with reinvestments we need RSGT or- alternatively- a
g#o$#tric $#an return over several eriods (RSGT is more convenient
since it also allows to comare two strategies with di!!erent investment
eriods)D
A7: It holds (1 +r)
5
= 2 thus according to the !ormula ?JSLJ?
r = 0:14870 which is retty ambitiousD Uor comarisonN the fSY
(German counterart o! fow Jones Industrial Sverage) has a longJ
term RSGT about IZD \n the other hand "arren #u!!et achieves
=>Z RSGTD
A8: This Puestion is not trivialD S correct but an incomlete answer
is as !ollowsN one in a thousand is >D?Z thus the robability o! the
allergic resonse is also >D?ZD Sccording to Thilo FarraWin only @LZ
??

o! Germans and =MZ o! Smericans can rovide this answer
E
D The
roblem is- however- that >D?Z is [ust an emirical estimation o! the
`genuinea robability but not the genuine robability itsel!D The
more the number o! trials (in this case the number o! ersons that
took the medicine) the better is the convergence o! the estimate to
the genuine robabilityD The underlying theory is !ar !rom being
easyD Uortunately there is an accessible alternativeN the Monte Rarlo
simulation- which will be one o! the most imortant tools !or usD
A9: Smong KL cards there are @ PueensD Uor a wellJshu!!led deck
each card can be drawn with ePual robability- which is ?OKLD In
!our cases there can be a Pueen- so the total robability is @OKL o
?OH o ??D??ZD Snalogously there are H sades thus the robability
to get a sade is ?O@ o =MZD Uinally- there is only one Pueen o!
sades- so the robability to get it is ?OKL o =DEIZD Bote that the
suit o! a card is obviously indeendent !rom its valueD \n the other
hand the robability to draw the Pueen o! sades is numerically
ePual to the roduct o! robabilities to draw a Pueen and to draw
sadesD In general- i! the events S and # are indeendent then the
robability that both S and # will occur is ePual to the roduct o!
their robabilitiesD Moreover- the converse is also true- iDeD i! the
!ormula ?JSHJ? holds then the events S and # are indeendentD
P(AB) = P(A)P(B)
Formula 1-A9-1 Qrobability law !or indeendent events

A10: This case is a er!ect demonstration o! the VcontradictionsV
between the emirical and the genuine robability or- as some
eole say- between mathematics and hysicsD S VhysicistV will
conclude that the coin is heavily biased- so the robability to get a

E
TD FarraWin- Vfeutschland scha!!t sich abVD Lth ed(=>?>)- D ?HL
Thilo FarraWin (born in ?H@M) was a very success!ul senator !or !inance in #erlin
and a member o! the bXecutive #oard o! the German Rentral #ank (#undesbank)D
?=

head by the neXt toss shall be close to ?D Cowever- a
VmathematicianV will assume a !air coin and thus state that the
robability to get a head by the ??th toss is still >DM- since the toss
outcomes are indeendent !rom each other
I
D Bote that i' the coin is
!air- the robability to get ?> heads by ?> tosses is- according to the
!ormula ?JSHJ? ePual to (0:5)
10
= 0:0009765625 0:1%D It is
eXerience and not mathematics that lets us decide whether to
consider an event virtually imossible or retty rare but still
ossibleD In case o! a 'air coin I would rather say- it is virtually
imossible to get ?> heads by ?> tossesD #ut an allergic reaction o!
one atient among one thousand does not imly (at least to me)
that the allergy is virtually imossible- though the robability o! this
event is >D?Z as wellDDD Rontinuing on with this idea- there is one
more eXamle- which I learnt !rom the wonder!ul teXtbook on
robability theory by blena "enWel
H
N i! you are an artillerist- you
likely can accet that one o! a thousand shells will not eXlode by
hitting a targetD #ut i! you are a aratrooer- the robability o! >D?Z
to have your arachute undeloyed will likely be too high !or youD
A11: The !irst bank account ays LZ return to the end o! the yearD
The second ays o!! (1 + 0:03)
2
= 1:0609 (!irst ayment takes lace
a!ter siX months and the second to the end o! the year)D
Snalogously !or the third account we have (1 + 0:015)
4
= 1:06136
and (1 + 0:005)
12
= 1:06168 !or the !ourthD Fo there is a di!!erence-
although not really a big oneD "hat i! we continue this rocess to its
limit (and does this limit eXist at all)lq res- it doesq This is known as
contin!o!&ly co$po!nd#d int#r#&t and it is very oular in the
theory o! mathematical !inanceD
lim
n!1

1 +
r
n

t
n
= exp(rt)
Formula 1-A11-1 Rontinuously comounded interest

I
In other words they are serially indeendentD
H
blena Fergeevna "entWel (?H>EJ=>>=) was a rominent Foviet mathematician
and writer (she wrote under seudonym ID Grekova that literally means VMrsD rV)D
?K


"e can also obtain the !ormula ?JS??J? the other way aroundD
Sssume that the wealth in a bank account grows roortionally to
its current value W
t
with coe!!icient r- iDeD the !ollowing di!!erential
ePuation holdsN dW
t
= rW
t
dtD The solution is W
t
= W
0
exp(rt)
where W
0
is the initial wealthD
Aery close is the idea o! the logarith$ic r#t!rn&- iDeD i! the initial
wealth was W
0
- the terminal wealth is ePual to W
1
and the
investment eriod was t years then the logarithmic return is
r =
1
t
ln

W
1
W
0

=
ln(W
1
) ln(W
0
)
t

Formula 1-A11-2 dogarithmic returns

Indeed- i! the interest is comounded continuously then
W
1
= W
0
exp(rt) thus ?JS??JS= holdsD dogarithmic returns are
convenient !or continuous time models
?>
D Fince the stock trading is
essentially discrete- we will mostly use comound returns according
to ?JSLJ?D

Bow we turn to the robability theoryD Ss you may know- it
originates !rom gamblingD The easiest case is a symmetric coinN the
robabilities o! head (C) and tail (T) are both ePual to >DMD Cowever-
the Puestion Vwhat is the robability to get at l#a&t one head i! we
toss a symmetric coin twiceV is not comletely trivialD Ftill we can
enumerate all ossible outcomesD They are CC- CT- TC and TTD The
!irst three outcomes suit our criterionD Fince the coin is symmetric-
they all have the same robability- which is ePual to >D=M] recall that
the robabilities o! all ossible (and mutually eXclusive) outcomes

?>
In articular due to the !act that a comound return on a long and nonJ
leveraged osition can take values in `J?- 1a- whereas a logarithmic return can lie
in `1- 1a and thus can be straight!orwardly modeled by continuous robability
distribution like the normal distributionD
?@

must sum to oneD Thus the robability o! the event to get at least
one head by two tosses is >DEM or EMZD
Fo !ar so good but what i! we want to calculate- say- the robability
to get at least L> heads by ?>> tosseslq The enumeration o! the
outcomes does not seem to be !easible anymoreD "e still could
have solved this roblem analytically but we actually need notD
Instead we can engage T- an oensource and royaltyJ!ree statistical
so!twareD
jeXact value
rint(VbXact FolutionV)
? J binom(MH- ?>>- >DM)

jaroXimate value by Monte Rarlo simulation
tosses o rbinom(?>>>>>- ?>>- >DM)
nFuccess!ul\utcomes o >
!or(i in ?N?>>>>>)
s
i!(tosses`ia toL> )
nFuccess!ul\utcomes o nFuccess!ul\utcomes _ ?
u
rint(VSroXimate FolutionV)
nFuccess!ul\utcomes O ?>>>>>
R-code 1.1 Qrobability o! at least L> heads by ?>> tosses

I! you never heard about T be!ore- donmt worryD Fo !ar [ust go to
httNOOwwwDrJro[ectDorg- download and install T (the installation
on "indows is straight!orward) and enter the TJcode ?D? to the
command lineD Uurther we will learn the basics o! T iteratively ste
by steD det us discuss the TJcode ?D? in detailD The command
binom(MH- ?>>- >DM) in the Krd line gives the eXact value o! the
robability that there will be no more than MH heads by ?>> tosses
o! a symmetric coin (>DM stands !or the robability o! head)D
Tesectively- the robability that there will be L> or more heads is
? J binom(MH- ?>>- >DM) D
Cere we made use o! our knowledge o! the robability distributionD
#ut this will not always be the caseD Uor eXamle- we may draw the
stock returns !rom a (sohisticated) distribution and have no idea o!
?M

the distribution o! terminal wealth (though the distribution o!
returns is known)D #ut it is absolutely no roblem as long as we
have T at hand
??
D Sll we need to do is [ust to run a Monte Rarlo
simulation- which is- in our case- nothing else but a comuter
simulation o! the coin tossesD The command
tosses o rbinom(?>>>>>- ?>>- >DM) tells T to simulate ?>> tosses o! a
symmetric coin- calculate the sum o! heads- reeat the rocess
?>>>>> times and ut the values to the array VtossesVD Rommand
nFuccess!ul\utcomes o > initiates the counter o! outcomes with L>
heads or moreD Then we run through all outcomes with a 'orJloo
and check whether we got the desired number o! headsD I! yes- we
increment n(!cc#&&'!l)!tco$#& by oneD In the last code line
nFuccess!ul\utcomes O ?>>>>> we divide the number o! success!ul
outcomes by the total number o! trialsD The more it is- the better
the !inal result converges to the genuine robability o! the event to
get L> heads or moreD
In my case the genuine robability was >D>=I@@KHE (and will
obviously be the same in your case)D Ss to the aroXimate
robability- I yielded >D>=IHL which is retty close to the genuine
valueD Cowever- in your case it will be slightly di!!erent- though
most likely also close to the true valueD

I! you are comletely new to rogramming- do the !ollowingN
?D Tead more about arrays (in rincile- an array is [ust a
sePuence o! values)D
=D Tead about loos (loos are used to reeat the same or the
similar actions many times)D #esides 'orJloo- learn also whil#J
looD
KD dearn the conditional oerator i' and its eXtension i' ... #l&#
as well as logical oerators and- or- not (in T they are-
resectively- written as **- ++- ,) D
@D Bote the di!!erence o! the assignment oerator o
and its synonym vJ vsD VePual toV oerator oo D
Exercie 1.1 !"ro#rammi$#%

??
The only roblem we may encounter is the comutational intensityD
?L


#y means o! this simle Monte Rarlo simulation we
addressed two imortant toicsN the (discrete) stochastic rocesses
and (the convergence to) the eXectation o! a random variableD det
us so !ar ostone the !ormer and discuss the latterD I! we assign ?
to head and > to tail- the eXected value o! a single coin toss is >DMD
Tecall the de!inition o! the eXectationN

E[X] :=
n
P
i=1
p
i
X
i

&e'i$i(io$ 1.1 bXectation o! a discrete random variable

where X
i
is the value o! a random variable in case o! outcome i and
p
i
is the robability o! this outcomeD In our eXamle let
?=

X
1
:= fX = Tg = 0- X
2
:= fX = Hg = 1
Fince the coin is symmetric- p
1
= p
2
= 0:5 and
E[X] = p
1
X
1
+p
2
X
2
= 0:5 0 + 0:5 1 = 0:5
Bote that sometimes we can calculate the eXectation [ust by
intuition
?K
D Indeed- i! we toss a symmetric coin ?>> times- we
should get aroXimately the same number o! heads and tailsD Fince
we assigned ? to head and > to tail- the eXectation is M>D

Bow let us note a very imortant idea- which you (or your
instructor) may have missed out in your !irst course on robabilityD

In case o! a single toss (or [ust a !ew tosses) the eXectation is not
really meaning!ulq



?=
VNoV means VePual by de!initionVD The eXression X
1
:= fX = Tg is read as
!ollowsN by de!inition let the !irst outcome take lace when we got a tail by a coin
tossD
?K
#ut be care!ul- in mathematics the intuition can easily let you downq Thatms why
always veri!y it by a Monte Rarlo simulationq
?E

Indeed- the eXectation is [ust the average value- but does
averaging really make sense in case o! [ust one coin tossl The
situation radically changes i! we toss a coin many times (the more-
the better)D #y hundred tosses the robability to get #xactly the
eXected value- iDeD M>- is about IZ which does not seem to be very
largeD Cowever- the robability that the outcome deviates !rom the
eXected value by no more than w?> is more than HMZq rou can
check it with T command binom(L>- ?>>- >DM) J binom(KH-?>>->DM) D
It means that in a sense th# rando$ o!tco$# -#co$#& l#&& and l#&&
rando$ a& w# incr#a&# th# n!$-#r o' trial&D In other words the
mean value o! the eXeriment converges to its eXectationD

Cere we smoothly ste to the neXt imortant concetN the variance
and the standard deviation (that are direct relatives o! the assets
volatility)D det us slightly modi!y our eXamleN instead o! a coin toss
consider a stock S- which can either !all MZ down or grow ?>Z uD
Uurther let stock # go either K>Z u or =MZ downD Bote that in
ractice we can o!ten estimate these numbers relatively recisely
and even d#'in# them- eDgD i! we set our take ro!it and sto loss
orders accordingly
?@
D det the robabilities
?M
o! both events be >DMD
Sccording to the de!inition ?D? both stocks have the same eXected
returnD IndeedN 0:5 0:1 + 0:5 (0:05) = 0:025 = 2:5% and
0:5 0:3 + 0:5 (0:25) = 0:025 = 2:5%D
Cowever- you (should) intuitively !eel that the stock # is much more
riskyD Indeed- !or both stocks we eXect the same return but we
know that by the stock S we will not lose more than MZ o! our
investment even in the worst caseD \r in other words- the worst
ossible deviation !rom the eXected return is ePual to
JEDMZD #ut !or the stock # it is J=EDMZq


?@
\! course there is always a chance that the traded asset will reach neither sto
loss nor take ro!itD Cowever- eXerienced traders rarely encounter this case-
later we will discuss whyD
?M
Ss to the robabilities- they are really hard to estimateD Cowever- it is not an
insuerable hindranceD dater we will consider how to deal with itD
?I

St this oint we are getting somewhat messy since we miX the
variance and the (maXimum) drawdown riskD They are not the
sameD Cowever- as long as the returns never deviate too !ar !rom
their eXectations
?L
- the drawdown risk and the variance are very
closely relatedq rou will see this in the neXt chaterD

Fto reading !or a while and have a cu o! teaD Imagine that
you have lost MZ o! your savingsD Cow do you !eell Bow
imagine that the loss is =MZD Cave you lanned to buy a house
or a new carl \r maybe an eXensive vacationl "hich loss
would be accetable !or you so that you still could a!!ord all
your lansl
Exercie 1.2 !"yc)olo#y%

Bow let us !ormally de!ine the variance and the standard deviationD

VAR[X] := E[(X E[X])
2
]
&e'i$i(io$ 1.2 Aariance o! a random variable

StdDev[X] :=
p
VAR[X]
&e'i$i(io$ 1.3 Ftandard deviation o! a random variable

bssentially- th# &tandard d#.iation $#a&!r#& th# di&p#r&ion o' th#
o!tco$#& 'ro$ th#ir #xp#ct#d .al!#D rou may wonder why we at
!irst consider E[(X E[X])
2
] and then take the sPuare root instead
o! simly considering E[(X E[X])]D Ss a matter o! !act-
E[(X E[X])] = 0 (as a good eXercise- rove this statementq Just
aly the de!inition ?D?D Ss a use!ul corollary you will get that

?L
\r- in mathematical terms- as long as the return distribution has no !at tailsD
?H

E[E[X]] = E[X] and- in general- the eXectation o! a constant is
this constant itsel!)D Sdditionally- the advantages o! the de!initions
?D= and ?DK become evident as soon as one encounters the lin#ar
r#gr#&&ionD
det us calculate the variance o! returns on stocks S and #D Uor
convenience- we summariWe the ossible outcomes and their
robabilitiesD In other words- we seci!y the robability
distributions !or the random returns o! the both stocksD
Qrobability Teturn on stock S Teturn on stock #
>DM J>D>M J>D=M
>DM >D? >DK

"e have already calculated that E[A] = E[B] = 0:025 Sccording to
the de!initions ?D= and ?DK- we calculate
VAR[A] = 0:5 (0:10:025)
2
+0:5 (0:050:025)
2
=
0:005625
VAR[B] = 0:5 (0:30:025)
2
+0:5 (0:250:025)
2
=
0:075625
Cence StdDev[A] = 0:075 and StdDev[B] = 0:275

=>

Chapter 2: Money Management according to Kelly
criterion: the first encounter

bvery highly Puali!ied telecommunication engineer knows
the (basics o!) in!ormation theoryD This theory does not tell him
how to design the devices with the maXimum bandass but it does
tell him which bandass he can theoretically achieveD Fince our
engineer is highly Puali!ied- he knows that ractically achievable
bandass will be somewhat below the theoretical oneD
"e J the !inanciers J have our own analogue o! the in!ormation
theory that tells us- which maXimum eXected growth rate- iDeD
which RSGT- we can achieve in the long termD This V!ortunems
!ormulaV is known as Kelly criterionD Furrisingly- it was Rlaude
Fhannon (the !ather o! the in!ormation theory)- who signi!icantly
contributed to its discoveryD bven more surrising is that very !ew
!inancial ro!essionals are (really) aware about Kelly criterionD St
the same time every gambler knows itD

S short historical review o! Kelly criterion is Puite aroriate
here
?E
D The original aer VS Bew Interretation o! In!ormation
TateV
?I
was written by JD dD Kelly- JTD in ?HMLD In essence- it considers
a !avorable game
?H
and the otimal !raction o! gambling caital-
which one should bet by each stakeD #ut !rom the tradersm and
bettorsm oint o! view the ublished version is retty vagueD Though
one can gras the main idea- the aer is rather about
communication channels than about otimal stakesD Sllegedly-
there was an earlier version- written both by Kelly and FhannonD In
this version the author(s) !reely talked about bookies and insidersD
#ut both authors worked !or STxT- whose management Vwas never

?E
Uor the most art I !ollow James Rasems aer VThe Kelly RriterionN Uallacy or
Kuhnian Qaradigm Fhi!t "aiting to CaenlV (FISM Bews- Aolume KH- Bumber K-
Sril =>>L- available at httNOOwwwDsiamDorgOd!OnewsOHK>Dd!)
?I
Svailable at httsNOOwwwDrincetonDeduOywbialekOromeOre!sOkellykMLDd!
?H
Uavorable game is a game with a ositive eXectationD The simlest case is
tossing o! a nonJsymmetric coinD \ositely- in case o! a symmetric coin the
eXectation is Wero- so one seaks about 'air gameD
=?

keen to advertise the !act that bookies long reresented an
embarrassingly large !raction o! the !irms customer baseVD Ss a
result- the authors reared a Vmore olitically correctV version-
signed by Kelly aloneD

S coule o! years later bdward Thor
=>
- a ro!essor o! mathematics
at MIT !ound out how to get an edge in black[ackD Fhannon was a
good !riend o! Thor and drew his attention to Kellyms aerD Kellyms
aroach allowed Thor to maXimiWe in long t#r$ the advantage o!
his edge in black[ackD Thor alied his strategy in das Aegas casinos
and made good moneyD Fuccess!ul gamblers are Puickly recogniWed
and eXelled !rom casinos- so Thor had to disguise himsel! in a
combination o! wraaround glasses and a beard in order to avoid
eXulsionD
ret a casino a!!air was [ust a warmJu !or ThorD Cis real deal was
the statistical arbitrage- iDeD the eXloration o! the market
imer!ections that though not necessarily guarantees a riskless
ro!it but rovides a sure edge Von averageVD In an e!!icient market
there are no such imer!ections but Thor never believed the
markets were e!!icientD zzIn the late ?HE>s a!!ordable- ower!ul
comuters and high Puality databases were becoming more
a!!ordable- making a revolution in Uinance ossibleDDD The idea was
to rank stocks by their ercentage change in rice- corrected !or
slits and dividends- over a recent ast eriod such as the last two
weeksD "e !ound that the stocks that were most u tended to !all
relative to the market over the neXt !ew weeks and the stocks
which were the most down tended to rise relative to the marketD
csing this !orecast our comuter simulations showed aroXimately
a => ercent annualiWed return !rom buying the best decile o!
stocks- and selling short the worst decile
=?
{{D Qro!D Thor is a
seminal writer] however- he never disclosed in d#tail how he
alied Kelly criterion to his ort!olio o! $any assetsD "e will

=>
httNOOenDwikiediaDorgOwikiObdwardk\DkThor
=?
bd Thor- S Mathematician on "all FtreetD Ftatistical Srbitrage J Qart IID
httNOOwwwDwilmottDcomOd!sO>I>LK>kthorDd!
==

discuss this issue later but so !ar consider the Kelly criterion in its
simlest univariate !ormD

Sssume a gambler tosses a biased coin so that the
robability p to get a tail is known and larger than >DMD (In our
terms- it is a !avorable game and a gambler has an edge)D S!ter each
bet a gambler loses or doubles the money at stakeD \bviously- he
wants to eXloit his edge comletely and at !irst glance the idea to
maXimiWe his #xp#ct#d t#r$inal w#alth (recall de!inition ?D?) does
not look imlausibleD det W
0
be his initial caital and let ! be the
!raction that the gambler bets at each stakeD Tesectively- he lays
aside (1-!)D Then the eXected caital a!ter the !irst bet is
W
0
[2pu + (1 p) 0 + (1 u)] = W
0
[2pu + 1 u]
Tesectively- the eXected caital a!ter the second bet is
W
0
[2pu + 1 u]2pu +W
0
[2pu + 1 u](1 u)
= W
0
[2pu + 1 u]
2

Uor n bets one has E[W
n
] = W
0
(2pu + 1 u)
n
D \bviously- this
eXression is growing with ! (recall- p t >DM thus p t ?)D Thus in
order to maXimiWe the eXected terminal wealth a gambler should
ut at stake all his caital by each betD Cowever- this is too risky
because each bet looms the danger to lose everything and as the
number n o! bets gets larger and larger a gambler will eventually go
bankrut (recall n?> !rom the PuiW)D Thus | i! the winnings are r#-
in.#&t#d J the idea to maXimiWe the eXected terminal wealth is
actually bad and our gambler needs another aroachD \n the
other hand i! he bets nothing (iDeD lets ! o >) he will make no use o!
his edgeD Fo the otimal !raction is somewhere between Wero and
one- but wherelq

Ss an alternative to the maXimiWation o! the eXected terminal
wealth- Kelly suggested to maXimiWe the #xp#ct#d growth rat#
(recall nM and nE)D Indeed- one can make an outstanding series o!
returns- say =>Z- K>Z and I>Z- which corresonds to a total return
o! (?_>D=)(?_>DK)(?_>DI) J ? o ?I@Zq
#ut then one may have a bad luck and get a return o! JE>ZD Then
the total return will be JK@D@IZ (recall nM)q In this sense the
=K

maXimiWation o! the eXected growth rate means that we limit the
a!termath o! severe negative returns- because [ust one such
negative return can drastically reduce our wealthD St the same time
we su!!iciently articiate in ositive returnsD Thus in the long run
Kellys aroach beats any oth#r aroachq

Ss you may have noted- in case o! reJinvestment o! winnings the
wealth grows eXonentially in time- iDeD the time (or the number o!
investment eriods) stays in the eXonent (recall !ormula ?JSLJ?)D
Thus the maXimiWation o! the eXected growth rate actually means
the $axi$i"ation o' #xp#ct#d logarith$ic t#r$inal w#alth ln(W
n
)D I!
we hold an asset !or n eriods !or which the returns are random
than we have
W
n
= W
0
(1 +r
1
) (1 +r
2
) : : : (1 +r
n
)
Taking logarithm we turn this roduct into a sum and maXimiWe
E[ln(1 +r
1
) + ln(1 +r
2
) +: : : + ln(1 +r
n
)]
S reader- who is !amiliar with utility !unctions- will readily ask
whether we [ust maXimiWe the logarithmic utilityD In a sense- yes-
and Kelly did recogniWe this asect o! his aroachD #ut he always
ointed at the !act that his argumentation has nothing to do with
utility !unctions and this connection to the logarithmic utility is [ust
a coincidenceD Cowever- it is a very hay coincidenceq Uirst o! all
because the logarithmic utility is $yopic

D That is- though we have

many bets (or investment eriods)- we need to act by each bet as i'
it w#r# th# la&t on#q Bormally- this is not the case and one
otimiWes running backwards
=K
D Indeed- as blena "enWel eXlains-
why should we otimiWe the !irst ste when the second ste takes

==
dogarithmic utility has many other nice roertiesD In general- some utility
!unctions (!irst o! all the logarithmic and negative ower utility) are much more
use!ul than the othersD cn!ortunately- the teXtbooks on economics usually
consider the utility !unctions very suer!icially- so that the students get a wrong
imression that utility !unctions is a nice theoretical concet- which is- however-
useless in racticeD
=K
This aroach was introduced by Tichard #ellman(?H=> J ?HI@)- who called it
dynamic rogrammingD #y that time the words comuters and rogramming
were the buWW words and #ellman made use o! it in order to obtain a grant !or his
researchD
=@

us | directly or !iguratively | in a swamlq Thats why we should
rather trace our route backward !rom destination to the start and
otimiWe iterativelyD Uor this we need to know all ossible routes
and the number o! stesD Cowever- in case o! an `activea wealth
management we usually do not know how many trades we will
commitD #ut in case o! acting according to the Kelly criterion we
simly do not need to know itq "e [ust otimiWe every trade as i! it
were the last oneq

Moreover- under !airly general conditions the Kelly criterion
maXimiWes the $#dian
=@
o! the terminal wealthD Ss a measure o!
central tendency- the median is o!ten re!erred to the eXectationD
Indeed- assume we need to sum u with a single number the
in!ormation about the wealth o! a grou o! !ive eole (such as an
owner o! a comany and his emloyees)D I! a business owner earns
^?>>>>>> er year but ays his emloyees relatively modest annual
salaries o! ^K>>>>- ^@>>>>- ^M>>>> and ^L>>>> then the mean (or
eXected income) is ^=KL>>> but the median is ^M>>>>- which is
obviously much more reresentativeD

Bow let us consider the !ollowing eXamle
=M
N assume there is a
stock
=L
that yields !or each dollar invested- ^=DE> or only ^>DK>-
both with robability ?O=D Sccording to the de!inition ?D? this is a
er!ect investment oortunityN the eXected wealth is
0:5 (2:7 + 0:3) = 1:5- iDeD the eXected return is M>Zq Fo !ar- so
good and it does not seem imlausible to invest all our caital in

=@
bthier- FD BD (=>>@)D The Kelly system maXimiWes median !ortuneD Journal o!
Slied Qrobability- @?(M)N?=K> | ?=KL
=M
It is Famuelsons eXamleD Qaul Famuelson (?H?M J =>>H) was a Bobel QriWe
winner in economics and the main critic o! Kelly criterion- see The !allacy o!
maXimiWing the geometric mean in long sePuences o! investing or gamblingD
Qroceedings o! the Bational Scademy o! Fciences- LI(?>)- =@HKJ=@HL)D In this
sense- it is esecially interesting to beat such a rominent critic with his own
eXamleD Famuelson actually imosed a constraint either to invest in stock
co$pl#t#ly or not at allD #ut who can imose such constraint to a trader in a !ree
society and a liberal marketlq
=L
Snd there ar# suchlike stocks- eDgD Bokia (UI>>>H>>>LI?)
=M
this stockD #ut look what haens in the long runq Fince the
robabilities to go u and down are ePual- we can eXect that the
number o! us and downs will be aroXimately ePualD Tecall our
eXamle with ?>> coin tosses- it is comletely analogousN i! we hold
this stock !or ?>> investment eriods- the robability that the
number o! downs remains between @> and L> is more than HMZD #y
?>> trades and a tyical M>OM> scenario we yield
[(0:3)(2:7)]
50
= [0:81]
50
0 - iDeD we are brokeq In order to make a
ro!it we need at least MM usN (0:3)
45
(2:7)
55
= 1:56842 D #ut the
robability to get MM or more us is [ust ?ID@?Z (check it with T
analogously to TJRode ?D?)q Tesectively- the robability to make
loss is I?DMHZ- which is too much !or a tyical riskJaverse investorD
#ut look what haens i! we always hold eXactly @=Z o! our wealth
in stock and the rest in cashD It means that a!ter each trade we sell a
art o! stocks i! they went u and buy i! they went down so that by
each trade the wealth !raction invested in stock remains @=ZD In
this case we yield by a tyical scenario
([(1 0:42)
| {z }
in cash
+2:7 (0:42)
| {z }
in stock
][(1 0:42)
| {z }
in cash
+0:3 (0:42)
| {z }
in stock
])
50
=
[(1+1:7 0:42)(10:7 0:42)]
50
= [(1:714) (0:706)]
50
=
13828:53
"hat an imrovement [ust by means o! a clever money
managementq Moreover- even i! we encounter the worst o! the
tyical scenarios- iDeD [ust @> us and L> downs we still make ro!it
since (1:714)
40
(0:706)
60
= 1:94 D That is- with robability o! more
than HMZ we do make ro!itq
=L


installDackages(VtseriesV)
library(tseries)
BkTTSfbF o K>
outcomes o rbinom(BkTTSfbF- ?- >DM)
wealth o array(?D>- dimoBkTTSfbF)
wealthKelly o array(?D>- dimoBkTTSfbF)
wealthCal!Kelly o array(?D>- dimoBkTTSfbF)
!or( i in =N(length(outcomes)) )
s
i!(outcomes`ia oo >) s
wealth`ia o wealth`iJ?a p (? J >DE)
wealthKelly`ia o wealthKelly`iJ?a p >D@= p
(? J >DE) _ wealthKelly`iJ?a p (? J >D@=)

wealthCal!Kelly`ia o wealthCal!Kelly`iJ?a p >D=? p
(? J >DE) _ wealthCal!Kelly`iJ?a p (? J >D=?)
u
else s
wealth`ia o wealth`iJ?a p (? _ ?DE)
wealthKelly`ia o wealthKelly`iJ?a p >D@= p
(? _ ?DE) _ wealthKelly`iJ?a p (? J >D@=)

wealthCal!Kelly`ia o wealthCal!Kelly`iJ?a p >D=? p
(? _ ?DE) _ wealthCal!Kelly`iJ?a p (? J >D=?)
u
u
=E
chartrmin o min(c(wealth- wealthKelly- wealthCal!Kelly))
chartrmaX o maX(c(wealth- wealthKelly- wealthCal!Kelly))
tsDlot(wealth- lwdo?- ylimoc(chartrmin- chartrmaX))
lines(wealthKelly- lwdo=-)
lines(wealthCal!Kelly- ltyo=- lwdo=)
Fi#ure 2.1 Kelly- hal!JKelly and !ull investment a!ter K> trades (a
samle scenario)D
The constant !raction o! @=Z is nothing else but the otimal
solution according to the Kelly criterionq Fince the logarithmic utility
is myoic- it su!!ices to consider a single tradeD Fo we need to
maXimiWe
0:5 ln(1 + 1:7u) + 0:5 ln(1 0:7u)
It is u = 0:42 that maXimiWes this eXressionD rou can check it
analytically i! you have a working knowledge o! calculusD \r-
alternatively- we can !ind it numerically with TD
u o seP(?-?>>)O?>> j!ractions
eXectedGrowthTates o >DMp(log(? _ ?DEpu) _ log(? J >DEpu))
lot(u- eXectedGrowthTates- tyeoVlV- lwdo=)
abline(vo>D@=- coloVgreyV)
abline(hoeXectedGrowthTates`@=a- coloVgreyV)
abline(hoeXectedGrowthTates`?>>a- coloVgreyV)
whichDmaX(eXectedGrowthTates)
Fi#ure 2.2 bXected growth rate vsD caital !raction in stockD
=I

#ut looking at !igure =D? you will robably say that even Kelly
strategy is too riskyN though the terminal wealth is good the
intermediate dro !rom => to @ (iDeD the drawdown o! JI>Z) is not
accetableD In this case you should reduce the otimal !raction] a
common ractice is to halve itD This is so called hal!JKelly strategyD
Though its terminal er!ormance is not as good as Kellys
(asymtotically Kelly beats any other strategy) but it is much less
riskyD dook at !igure =D=q rou see that i! you bet less or more than
the otimal Kelly !raction- your eXected growth rate decreasesD Fo
i! you underbet- you decrease both eXected growth rate and riskD
#ut i! you overbet- the growth rate decreases but the risk growsq
Fince in ractice we can only aroXimately estimate the otimal
Kelly !raction (recall the case genuine robability vsD its emirical
estimate)- we would better underbetD This is also the reason why
the hal!JKelly strategy is so oular among ractitionersD

"e see that in Famuelsons eXamle the $axi$!$ ossible
eXected growth rate is about HDMZD It tells us what we can- in
principl#/ sPueeWe !rom this investment oortunity in the long
term
=E
D Sctually- such growth rate is not bad (it is better than by
fSY) but it would not even double your wealth in !ive years (recall
nE)D

Thus never believe books or eole that romise to make you
millionaireD I do not a!!irm that it is rincially imossible to turn a
coule `o! thousandsa o! bucks into millionsD Fometimes it haens-
as !or instance James TevFhark feQorre describes in his book
Invest dike a FharkN Cow a fea! Guy with Bo Job and dimited
Raital Made a Uortune Investing in the Ftock MarketVD The trick is
that MrD feQorre was lucky to invest in vastly trending marketsD
Sctually- he bought bubbles and sold them at the right timeD
Rurrently- he o!!ers wealth management according to his
Fhark!olio strategyD In this sense I sayN I believe he did indeed

=E
Romletely analogous to the in!ormation theory- which tells an engineer what
he can- in rincile- sPueeWe !rom his communication deviceq
=H
make several millions !rom ^K>>>> but I do not believe he will
reroduce this success with his Fhark!olio in the long termD
\nce againN the beauty and use!ulness o! the Kelly criterion is that it
lets you estimate what you can r#ali&tically eXect in the long termD
Ran one beat Kelly in short runlq \h- yes
=I
q #ut in the short run (or
more recisely with a small number o! trades or investment
eriods) it is rather a lottery than a systematic investmentD Tecall- it
makes little sense to seak about the eXectation by a single coin
toss but i! you toss a coin ?>> times- the number o! heads and tails
will be Puite close to the eXected valueD The same holds !or trading
and investmentN i! you do have an edge- you will ro!it !rom it in the
long termD #ut in the short term the randomness dominates and
what you get is more a matter o! chanceD
In this sense- I highly recommend you to read the book "hat I
have learnt losing a million dollars by Jim Qaul (!ormer governor o!
the Rhicago Mercantile bXchange)D It is a rare book- which also sells
a bitter truth rather than an `unrealistica hoeD The leitmotiv o! this
book is that the author got used to breaking the rules and
succeeded !or a whileD #ut once he !ailed } and lost everythingD
foes it not resemble the cases that we have consideredN to lose
most o! your wealth it su!!ices to get a severe negative return 0!&t
onc#- i! you overbetD #ut i! you !ollow the rules- iDeD bet otimally-
even a severe negative return will not make you bankrutD

rou are robably wondering- how we can aly Kelly criterion to
the stock marketD Uinally- the stock trading is not coin tossing and
there are not [ust two ossible outcomes like heads and tails but
much- much moreD This is o! course true but surrisingly a
continuum o! outcomes by stock trading can be very well
aroXimated by a simle model ~ la coin tossD
=I
Uor the technical details have a look at #rowne- FD(=>>>) Ran you do better
than Kelly in the short runl (Svailable atN
httNOOwwwDsbriskDcomO#rowneObeatkkellyDd!)
K>

In order to release the sueriority o! the Kelly criterion we need a lot or
trades (or bets) and the reinvestment o! winningsD The latter is very
imortant and robably makes the main di!!erence between gambling
and investmentD Indeed- according to the Kelly criterion we invest a
constant
=H
'raction o! our caital- eDgD @=Z as in the case aboveD #ut i!
we lay oker with !riends or roulette in casino- we usually ut a
constant a$o!nt o! money at stake- say- ^?>D In this case- i! we have an
edge- the caital grows not eXonentially but linearly thus it is lausible
to otimiWe the eXected terminal wealthD


I- !or one- do not lay roulette since it is un!avorable game due to
the `doublea WeroD Bor do I lay okerD #ut sometimes I buy outJo!J
theJmoney otions
K>
D Fuch otions- when care!ully selected- may be
considered as roulette with a ositive eXectationD The chance to
lose everything is still big but there are also some chances to yield a
lot o! moneyD My monthly ocket money budget is about e?>> but I
usually have no time to send it D \n the other hand I sometimes
buy a retty eXensive toy- say- a new accessory !or my comuterD
Thus i! I invest my ocket money in otions and make on average
e@> er trade- I yield ?=pe@> o e@I> to the end o! year- which is
enough !or eDgD an additional monitor (I have !our at home)D "ithin
the year there are months when I lose my ocket moneyD I! I made
ro!it in revious months- I can comensate my losses with itD #ut
even i! I started the year with losses- it is comletely no roblem !or
me to re!rain !rom going to a restaurant or bar during the !irst
coule o! monthsD Imortant is [ust to get ro!it to the end o! yearD
#ut I never con!use gambling with my ocket money and the
investmentq

=H
I! the odds change !rom trade to trade- the otimal Kelly !raction also changes
resectivelyD
K>
In Germany the otions- sold to retail investors- are usually called
\tionscheineD #ut they are essentially otions- iDeD the rights but not obligations
to buy (call otion) or sell (ut otion) an underlying at a given rice (strike)D The
most o! \tionscheine are Smerican- iDeD one can eXercise them any time be!ore
eXiry dateD Most o! traders do not eXecute but simly sell them (sD Rhater L)D