In this guide
Key takeaway: The Kelly Criterion determines the optimal proportion of your capital to allocate to each wager, accounting for your statistical advantage and available odds. In prediction markets, it guards against the two most damaging errors: wagering excessively (risking total loss) and wagering conservatively (forgoing available returns).
How you size each position separates sustainable traders from those who deplete their capital. The Kelly Criterion — a mathematical framework created by John Kelly, a researcher at Bell Labs in 1956 — calculates the theoretically optimal wager magnitude for achieving maximum compounded returns over time. Below is its application 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% likelihood that an outcome settles YES. The market is quoting 45 cents (suggesting 45% likelihood).
- 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
According to Kelly, commit 27.2% of your capital. If you have $1,000 available, this suggests a $272 position.
Why full Kelly is dangerous
The Kelly formula relies on knowing your true probability with certainty — a condition that never materialises in practice. Miscalculating your advantage results in severe overexposure. Experienced market participants favour fractional Kelly approaches:
- Half Kelly (f*/2): The industry standard. Surrenders roughly 25% of theoretical gains but cuts volatility in half
- Quarter Kelly (f*/4): Prudent method when edge estimates carry substantial uncertainty
- Capped Kelly: Establish a ceiling — never exceed 5-10% of capital on any single market, irrespective of the formula's suggestion
Applying Kelly to multi-market portfolios
When you maintain concurrent stakes across numerous prediction markets, individual Kelly allocations require recalibration. The aggregate of all Kelly fractions must remain at or below 1.0 (your entire bankroll). Practically speaking, restrict combined exposure to 50% or less, preserving capital for emerging opportunities.
When Kelly does not apply
The Kelly framework presumes you can reliably quantify your probability edge. Several contexts undermine this assumption:
- Situations characterised by extreme ambiguity (unprecedented circumstances lacking historical reference points)
- Interdependent markets (such as political markets where election results and legislative control move together)
- Markets where your analysis provides no advantage relative to prevailing prices
Leverage PolyGram's integrated Kelly Criterion calculator to determine position sizes ahead of each transaction. The analytics suite encompasses sensitivity charts and peak-to-trough loss measurements. Start trading on PolyGram →