How Produce You Lot Restrain Drawdown Using Kelly Formula?

As many of yous know, I am a fan of Kelly formula because it allows us to maximize long-term increment of equity acre minimizing the probability of ruin. However, what Kelly formula wont' preclude is a deep drawdown, though nosotros are assured that the drawdown won't last equally much equally 100%! This is unsatisfactory to many traders together with peculiarly fund managers, since a deep drawdown is psychologically painful together with may sweat yous to panic together with nigh downwards a strategy prematurely.

There is an slowly way, though, that yous tin role Kelly formula to boundary your drawdown to last much less than 100%. Suppose the optimal Kelly leverage of your strategy is determined to last K. And suppose yous solely let a maximum drawdown (measured from the high watermark, equally usual) to last D%. Then yous tin exactly gear upward aside D% of your initial total concern human relationship equity for trading, together with apply a leverage of one one thousand to this sub-account to decide your portfolio marketplace value. The other 1-D% of the concern human relationship volition last sitting inwards cash. You tin together with then last assured that yous won't lose all of the equity of this sub-account, or equivalently, yous won't endure a drawdown of to a greater extent than than D% inwards your total account. If your trading strategy is profitable together with the total concern human relationship equity reaches a novel high watermark, together with then yous tin reset your sub-account equity thus that it is i time again D% of the total equity, moving roughly cash dorsum to the "cash" account. Otherwise, yous proceed to hold the equity inwards the cash concern human relationship course of teaching from the equity of the trading sub-account.

Notice that because of this separation of accounts, this scheme is not equivalent to exactly using a leverage of L=K*D% on your total concern human relationship equity. Indeed, roughly of yous may last too nervous to role the total one one thousand equally leverage, together with prefer to role a leverage L smaller than K. (In fact, the mutual wisdom is that, due to estimation errors, it is never advisable to gear upward L to last to a greater extent than than K/2, i.e. half-Kelly.) The occupation alongside using a L that is too pocket-size is that, also non achieving maximum growth, the portfolio marketplace value volition last unresponsive to gains or losses together with volition stay relatively constant. Using the scheme I suggested higher upward volition cure this occupation equally well, because yous tin apply a higher leverage L_sub to the sub-account (e.g. role L_sub = L/D%) equally long equally L_sub < K, thus that the portfolio marketplace value is much to a greater extent than sensitive to your P&L acre however ensuring the drawdown volition non operate past times D%.

Has anyone tried this scheme inwards their actual trading? If so, I would last interested inwards hearing your sense together with encounter if do is equally proficient equally theory.