Tuesday, April 15, 2014

how to tell if your vertical credit spread is in the kelly zone

the criterion part of the kelly criterion is that the candidate trade must have an edge. the wiki page says that for the kelly number to be positive the following must be true:
b > q/p
  • b is the benefit to risk ratio
  • q is the probability of loss
  • p is the probability of success
applying the kelly criterion to vertical credit spreads results in a simple pricing rule by which one may calculate the even-money price for the spread. here 'tis:
c = q * w
  • c is the even-money credit collected for the vertical.
  • q is the probability of loss, as above.
  • w is the price width between the strikes.
for example, if you are pricing a put vertical on spy that has a width of $1 between the long and short options and the tos analyze tab shows a probability of loss of 37% then the credit one must collect to be at even-money is 37 cents. if you can collect more than that then you are in the kelly-zone, where the kelly formula will give a positive number.


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