In this guide
Key takeaway: The Kelly Criterion determines the optimal proportion of your capital to deploy on each trade, accounting for your edge and available odds. In prediction markets, it guards against two critical pitfalls: wagering excessively (and facing account liquidation) and wagering conservatively (and forfeiting potential returns).
How much to stake on any single position separates sustained profitability from account depletion. The Kelly Criterion — a mathematical framework introduced by John Kelly, a researcher at Bell Labs, in 1956 — delivers the theoretically ideal stake magnitude for compounding wealth over time. This guide walks through its mechanics in the context of prediction markets.
The Kelly formula
For a two-sided prediction market (YES/NO), the Kelly fraction calculates as:
f* = (p * b - q) / b
Definitions:
- f* = proportion of total capital to allocate
- p = your subjective win probability
- q = loss probability (calculated as 1 - p)
- b = decimal odds (return / investment). On a prediction market contract trading at price c, b = (1 - c) / c
Worked example
Suppose you assess a 60% likelihood that an outcome settles affirmatively. Current market quotation stands at 45 cents (suggesting 45% implied probability).
- p = 0.60, q = 0.40
- b = (1 - 0.45) / 0.45 = 1.222
- f* = (0.60 * 1.222 - 0.40) / 1.222 = (0.733 - 0.40) / 1.222 = 0.272
The formula recommends committing 27.2% of your capital. If your account holds $1,000, you would position $272 in this opportunity.
Why full Kelly is dangerous
The Kelly formula presumes you possess exact knowledge of your true probability — a condition that never materialises in practice. Miscalculating your advantage produces severe overexposure. Institutional traders adopt fractional Kelly universally:
- Half Kelly (f*/2): Industry standard. Surrenders roughly 25% of maximum growth but cuts drawdown volatility in half
- Quarter Kelly (f*/4): Risk-averse method when edge confidence is low
- Capped Kelly: Establish an absolute ceiling—typically 5-10% per contract—irrespective of Kelly's recommendation
Applying Kelly to multi-market portfolios
Operating across several prediction markets concurrently requires recalibrating individual Kelly percentages. The aggregate of all Kelly allocations must remain at or below 1.0 (your entire bankroll). Realistically, maintain cumulative deployment beneath 50% to preserve dry powder for emerging trades.
When Kelly does not apply
Kelly presupposes reliable probability estimation. Several conditions invalidate this assumption:
- Situations involving extreme ambiguity (unprecedented events without comparable data)
- Interdependent markets (a legislative vote and regulatory outcome share causality)
- Markets where you lack informational superiority relative to pricing
Leverage PolyGram's integrated Kelly Criterion calculator to determine position magnitude before each entry. The analytics suite encompasses payoff visualisations and maximum drawdown metrics. Start trading on PolyGram →