How Should Traders Spread Their Bets?
Effective bet spreading is important for traders to maximize returns while managing risk.
This article looks at various strategies and concepts that traders can use to optimize their betting approach.
Key Takeaways – How Should Traders Spread Their Bets?
- Match position size to conviction
- Allocate more capital to high-confidence trades and less to speculative ones.
- This optimizes risk-reward.
- Use timeframe-appropriate sizing
- Day traders should use smaller positions (0.5-2% of account) while long-term investors can go larger (10%+) due to reduced short-term volatility impact.
- Implement position limits
- Set maximum allocations (e.g., 5% per trade, 25% per sector) for proper diversification and risk management.
- Adapt to the market environment
- Reduce overall position sizes in high volatility periods and potentially increase allocations to high-conviction trades during market dislocations.
The Concept of Bet Spreading
Traders of all stripes rarely commit equal amounts of capital to each trade.
Instead they spread their capital based on conviction, portfolio structuring, return, volatility and other risk considerations (e.g., tail risk), liquidity, and various other considerations.
Bet spreading allows traders to:
- Diversify risk across multiple positions
- Take advantage of high-conviction opportunities
- Manage exposure to market volatility
- Optimize capital allocation for long-term profitability
Value Betting
What is Value Betting?
Value betting is the practice of placing bets or trades when expected value is in your favor.
This concept is used in all sorts of games and in probabilistic scenarios.
In trading, this means identifying assets that are undervalued by the market (or overvalued if shorting).
Implementing Value Betting in Trading
To implement value betting:
- Conduct thorough analysis
- Compare your estimated fair value to the current market price
- Enter positions when you believe there’s a significant discrepancy in your favor
Example
If you believe a stock’s fair value is $100, but it’s trading at $80, this could represent a value betting opportunity.
For day traders and other short-term traders, technical analysis considerations will be a bigger factor at that timeframe while more fundamentally oriented traders will typically trade over longer time horizons for such value considerations to transpire.
The Role of Conviction in Bet Sizing
Defining Conviction
Conviction refers to the level of confidence a trader has in a particular trade or investment thesis.
Balancing Conviction and Position Size
High-conviction trades warrant larger position sizes, while lower-conviction trades should have smaller allocations.
Example
If you’re highly confident in a trade based on extensive research and multiple confirming indicators, you might allocate 5% of your portfolio.
For a trade with less supporting evidence, you might only allocate 0.5%.
Portfolio Structuring Considerations
Thinking of a portfolio as a structured entity, rather than a collection of individual trades, is important for long-term success in trading.
This approach shifts the focus from chasing trades one after the other to building a system that can withstand various market environments and consistently generate returns over time.
What kind of base allocation works well and trading within that structure.
Here’s how this structured approach can help:
Defined Objectives and Risk Management
A structured portfolio starts with clear objectives and risk tolerance.
For example, what kind of volatility? What kind of tail risk (e.g., VaR, drawdowns) is acceptable?
This framework guides trade selection and sizing.
It moves away from impulsive decisions driven by market noise and emotions.
Diversification and Balance
Instead of concentrating bets on a few assets or strategies, a structured portfolio emphasizes diversification across asset classes, sectors, countries, and currencies.
This balance reduces the impact of any single trade or market event on the overall portfolio.
Strategic Allocation
A structured approach involves allocating capital to different assets or strategies based on their risk-return profiles and their role in the portfolio.
This allocation considers factors like economic outlook and the trader’s expertise.
If the strategic allocation a trader wants is 40% in stocks and 5% in commodities (with a mix of other assets for the remainder), then he/she knows their trading exposure at any given time should roughly match that.
Systematic Execution
A structured portfolio often incorporates systematic rules for entry, exit, and position sizing.
This disciplined approach removes emotional biases and follows predefined, logical rules.
Monitoring and Adjustment
This includes rebalancing positions, adapting strategies, and managing risk as markets change.
Benefits of a Structured Approach
- Reduced Risk – Diversification and risk management techniques minimize the impact of losing trades.
- More Consistent Returns – A well-defined strategy and disciplined execution can lead to more consistent returns over time.
- Improved Emotional Control – A structured approach reduces impulsive decisions driven by fear or greed.
- Adaptability – A structured portfolio can be adjusted to changing markets without sweeping changes.
Bet Spreading by Timeframe: Day Traders vs. Swing Traders vs. Position Traders vs. Investors
The timeframe of a trading strategy heavily influences the level of bet spreading and position sizing.
Generally, as the holding period increases, traders tend to use larger position sizes.
Day Trading
Day traders typically use smaller position sizes due to their short timeframes and the need for quick, frequent trades.
They face higher transaction costs and intraday volatility, necessitating tighter risk management.
Day traders might limit individual positions to 0.5-2% of their account.
Swing Trading
Swing traders, holding positions for days to weeks, can afford slightly larger sizes.
They have more time for trades to develop and can withstand some short-term volatility.
Typical position sizes might range from 2-5% of their account.
Position Trading
Position traders, who hold for weeks to months, can take on even larger positions.
With a longer-term outlook, they can weather more significant price swings.
Position sizes might go from 5-10% of their account.
Investing
Investors, with the longest time horizons (months to years to even decades), tend to have the largest position sizes.
Their extended timeframe allows for more passive positioning and the ability to ride out market fluctuations.
Investors might allocate 10-20% or more to individual positions, especially in core holdings.
For example, an investor who passively allocates to stocks might include one or just a few index funds.
Due to the diversified nature of most index funds, they can go larger in size.
Longer time horizons generally permit larger position sizes due to reduced impact of short-term volatility and lower trading frequency (e.g., transaction costs are lower).
Nevertheless, all traders and investors should still maintain proper diversification and risk management regardless of their timeframe.
The Kelly Criterion: A Mathematical Approach to Bet Sizing
Understanding the Kelly Criterion
The Kelly Criterion is a formula used to determine the optimal size of a series of bets to maximize long-term growth rate.
The Kelly Formula
f = (bp – q) / b
Where:
- f = fraction of bankroll to bet
- b = net odds received on the bet
- p = probability of winning
- q = probability of losing (1 – p)
Applying Kelly in Trading
While the Kelly Criterion was originally developed for other betting games outside the financial markets, it can be adapted for trading:
- Estimate the probability of a trade’s success
- Calculate the potential reward-to-risk ratio
- Use the Kelly formula to determine position size
Example: If you estimate a 60% chance of success on a trade with a 2:1 reward-to-risk ratio, the Kelly Criterion would suggest betting 20% of your bankroll.
Naturally, in practical trading applications, you’re not going to bet 20% of your bankroll on one trade, which leads us to modified Kelly approaches…
Modified Kelly Criterion Approaches
Fractional Kelly
Many traders use a fractional Kelly approach, betting a percentage of the full Kelly bet to reduce volatility.
Example: Using Half-Kelly, you would bet 10% instead of 20% in the previous example.
Some traders will go even more conservative than that, such as dividing by 10 to whatever the Kelly output is.
Adjusted Kelly for Trading
Some traders modify the Kelly formula to account for factors specific to financial markets:
f = (p(b+1) – 1) / b
Where b is the reward-to-risk ratio instead of net odds.
Position Sizing Limits for Prudent Diversification
Setting Maximum Position Sizes
For proper diversification, traders should set maximum limits on individual position sizes.
Common guidelines include:
- No single position exceeding 5% of the total portfolio
- No sector allocation exceeding 20-25% of the portfolio
- No single asset class going above 50% of the allocation (e.g., stocks, bonds, commodities)
The 2% Rule
Many traders follow the 2% rule, which states that no single trade should risk more than 2% of the total trading capital.
Example: With a $100,000 account, the maximum risk per trade would be $2,000.
Others will go with the 1% rule.
Practical Examples of Bet Spreading Strategies
Example 1: Diversified Stock Portfolio
Suppose you have $100,000 to invest in stocks:
- Blue-chip stock (high conviction) = 5% allocation = $5,000
- Growth stock (medium conviction) = 3% allocation = $3,000
- Speculative small-cap (low conviction) = 1% allocation = $1,000
- Remaining capital spread across other opportunities and cash
Example 2: Forex Trading with Kelly Criterion
A forex trader has a $50,000 account and is considering a EUR/USD trade:
- Estimated probability of success = 55%
- Potential reward-to-risk ratio = 1.5:1
Using the Adjusted Kelly formula: f = (0.55(1.5+1) – 1) / 1.5 = 0.0833
The full Kelly bet would be 8.33% of the account, or $4,165.
Using Half-Kelly for more conservatism, the position size would be $2,082.50.
Example 3: Options Trading with Position Limits
An options trader with a $200,000 account follows these rules:
- Maximum 5% account risk per trade
- No single position larger than 10% of the account
For a high-conviction trade:
- Max risk = $10,000 (5% of $200,000)
- Max position size = $20,000 (10% of $200,000)
The trader would choose the smaller of these two limits based on the specific option’s price and risk characteristics.
Adapting Bet Spreading to Different Market Environments
Adjusting for Volatility
During high volatility periods, traders may reduce position sizes across the board to manage increased risk.
Example: Cutting all position sizes by 25% when VIX > 40.
Capitalizing on Opportunities
In times of market dislocation, traders might increase allocation to high-conviction trades while maintaining overall risk limits.
Example: Increasing allocation to defensive stocks during an economic downturn, while staying within sector and position limits.
The Psychological Aspect of Bet Spreading
Overcoming Emotional Biases
Proper bet spreading helps traders overcome common psychological pitfalls:
- FOMO (Fear of Missing Out) – Having a structured approach means traders are less likely to overcommit to a single opportunity.
- Overconfidence – Setting position limits prevents traders from risking too much on any single trade.
Building Confidence Through Consistency
A well-implemented bet spreading strategy allows traders to:
- Withstand losing streaks
- Capitalize on winning streaks without excessive risk
- Maintain emotional equilibrium throughout market cycles
Conclusion
Effective bet spreading is a cornerstone of successful trading.
Combining value betting principles, conviction-based sizing, mathematical approaches, and prudent position limits can help traders create a strong framework for capital allocation.
No single approach is perfect for all situations.
The key is to develop a personalized strategy that aligns with your risk tolerance, trading style, and market outlook.
Regularly review and adjust your bet spreading approach as you gain experience and as the markets you trade change.