The keynote speech at today’s CBOE Risk Management Conference in Dana Point, CA was delivered by a legend in the business, Edward O. Thorp.  Thorp’s discussion focused on Position Sizing and Relation to Risk Management. 

Despite being an octogenarian, Thorp recently released a book that is a great mix of a memoir and sharing what he’s learned through his decades of experience with the financial markets.  I strongly recommend picking up a copy of A Man for All Markets. 

Thorp started out discussing his experience creating a black jack card counting system.  He applied the Kelly Criterion to determine betting size based on whether the cards remaining in the deck favored the player or the dealer.  He says he learned the discipline of money management through the experience of developing and implementing his card counting system. 

He started in the investment industry by trading warrants and hedging in a similar manner to the way that option market makers hedge their positions beginning in the 1960's.  When CBOE opened he was able to apply his pricing model to option trading which gave his firm an advantage on the majority of market participants. 

He noted that one of the common themes throughout his investing career was application of the Kelly Criterion.  The properties of the criterion involve trading for a long time and systematically approaching investments.  He notes that if you bet more than the Kelly Criterion suggests then it will not work properly, but it is possible to not bet the maximum as still achieve favorable returns.  When you choose to invest closer to the maximum suggested amount, the result will be great volatility of your returns. 

In investment world, Warren Buffett and Charlie Munger admitted at an annual meeting that they use something similar to the Kelly Criterion.  Also, Bill Gross used the card counting system to win at black jack and then used this discipline in the investing world. 

He noted that the Kelly Criterion can highlight the danger of leverage.  His example of this was the principals at Long Term Capital Management (LTCM) who bet well over the Kelly Criterion guidelines.  He avoided investing with LTCM because he was aware of this with respect to their approach and correctly felt that the overuse of leverage would catch up with them. 

Thorp finished up by taking questions from the standing room only audience with respect to the Kelly Criterion, his background in the option industry, and position sizing in the real world.