In this guide
Key takeaway: The Kelly Criterion calculates the optimal proportion of your capital to wager given your perceived advantage and available odds. In prediction markets, it guards against two critical pitfalls: deploying excessive capital (risking total loss) and deploying insufficient capital (forgoing potential returns).
How you allocate capital across trades separates sustainable traders from those who deplete their accounts. The Kelly Criterion — a mathematical framework created by John Kelly, a researcher at Bell Labs in 1956 — determines the theoretically ideal wager magnitude for compounding wealth over time. Below is guidance on implementing it within prediction markets.
The Kelly formula
For a binary prediction market (YES/NO), the Kelly fraction is:
f* = (p * b - q) / b
Where:
- f* = proportion of capital to allocate
- p = your assessed likelihood of success
- q = likelihood of failure (1 - p)
- b = net odds (payout / stake). For a prediction market share trading at price c, b = (1 - c) / c
Worked example
Suppose you assess a 60% probability that an outcome settles YES. The current market quotation stands at 45 cents (reflecting an implied 45% 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 Kelly formula recommends wagering 27.2% of your total capital. If your account holds $1,000, this translates to a $272 position in this opportunity.
Why full Kelly is dangerous
The Kelly formula presupposes you can pinpoint your true probability with certainty — a condition rarely met in practice. Miscalculating your edge upward produces severe overexposure. Experienced market participants routinely employ fractional Kelly:
- Half Kelly (f*/2): The industry standard. Surrenders roughly 25% of theoretical gains but halves drawdowns
- Quarter Kelly (f*/4): A prudent stance when edge estimates carry substantial uncertainty
- Capped Kelly: Establish a ceiling of 5-10% per single market, overriding Kelly's output if necessary
Applying Kelly to multi-market portfolios
When you hold concurrent stakes across numerous prediction markets, individual Kelly percentages require recalibration. The aggregate of all Kelly fractions must remain at or below 1.0 (your entire bankroll). Practically speaking, maintain cumulative exposure beneath 50% to preserve dry powder for emerging trades.
When Kelly does not apply
Kelly presumes you can reliably estimate your true probability. Several contexts violate this assumption:
- Highly ambiguous outcomes (unprecedented scenarios lacking empirical reference points)
- Interconnected markets (a presidential race and legislative composition are not autonomous events)
- Markets where your information set matches the collective view
PolyGram offers an integrated Kelly Criterion calculator to determine position magnitude ahead of execution. The analytics suite encompasses payoff visualisations and maximum drawdown metrics. Start trading on PolyGram →