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to Cryptocurrencies

Abstract

The Kelly criterion is a somewhat well-known investment concept in the finance field that

can help investors maximise the expected value of the terminal value of wealth. We

develop a new modified version of a Kelly criterion and test it in a variety of market

conditions and reference time periods. We show that using an exponentially weighted

moving average using a shorter time window, in this case 7 days, investors in the

cryptocurrency market are able to earn returns well above the benchmark; we also show

that in general, investors who are willing to tolerate some level of risk may be able to

outperform in the cryptocurrency market as it likely tends to becomes more normal over

time.

Keywords

Kelly criterion • Cryptocurrency • Exponentially weighted moving average • Exponential utility

1. Introduction

The classical approach to gambling involves a gambler calculating the amount of capital to bet

on each bet in order to maximise total returns in the long run while avoiding the risk of complete

loss. In investing, usage of the strategy known as the Kelly criterion is based on the same

concept – find the fraction of each investment size in each given time period so that the investor

maximizes their total long-term expected returns starting with their given level of capital. The

Kelly criterion in investing terms is typically defined as an edge-over-odds model where an

investor is only recommended to invest should the probability of earning positive return be over

50%, with the proportion of the starting capital to be invested calculated relative to the amount of

excess return, or edge, an investor can expect to receive on a given investment made. As such, a

typical Kelly criterion can be defined as:

𝑏𝑝 − 𝑞

𝑓= (1)

𝑏

Where f is the Kelly fraction (the fraction of available starting capital that should be staked on a

given favorable investment), b is the expected odds received on a given investment, p is the

probability of the investment earning a positive return, and q is the probability of the investment

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receiving a negative return. This is a strict representation of a typical edge-over-odds Kelly

criterion.

Kelly strategies in general tend to be popular amongst those who use them in both the gambling

and the investing scenarios due to the fact that by definition they can maximise growth of wealth

over time – but there are some clear risks involved. While some, such as Peterson (2018), have

attempted portfolio choice strategies utilising a Kelly criterion, most typical applications do

involve a relatively high level of risk to investors, largely due to a lack of diversification; a Kelly

strategy by its typical definition strictly involves putting some level of available capital into the

favorable asset and the remaining capital into a risk-free asset such as treasury bills.

This paper aims to develop a version of the Kelly criterion that can be used specifically with

more volatile investments, such as cryptocurrencies. As pointed out by MacLean, Thorp, and

Ziemba (2011), fundamentally mathematically a Kelly criterion strategy will maximize the rate

of asset growth (especially when compounding comes into play) and help avoid potential ruin,

even if there are generally more significant risks of losses being undertaken. This paper’s

proposed newer version of a Kelly criterion, utilising a novel way of splitting returns that could

theoretically benefit in a more volatile market (see Section 3), and tested against a relatively

newer market development in cryptocurrency, should help some investors – particularly those

who are more risk-seeking – navigate the market.

By testing this Kelly criterion in a variety of different investment scenarios, time periods,

utilising data over different periods, the optimal scenario or scenarios in which to apply both this

new Kelly criterion and a general version of Kelly criterion relative to the cryptocurrency market

can be found. This paper also aims to compare the Kelly criterion to the use of utility theory to

attempt to maximise expected utility for investors with a spectrum of risk tolerance to see the

potential gains relative to risk trade-off possible for the average investor.

This paper begins with Section 2 providing some background on theory and prior literature

related to the Kelly criterion, cryptocurrency, and utility. The methods and data used for the

study are then described in Section 3, after which the results used from the employment of these

methods and data are described in Section 4. Section 5 is a discussion of the results and the

implications thereof, and the paper ends with conclusion in Section 6.

2. Literature Review

Kelly (1956) developed a strategy for individuals to bet an optimal portion of their capital into

games with favourable odds to generate an exponential growth rate; however, this initial paper was

developed in reference to information rate and information theory rather than thought about in an

investment context. This strategy is known as the Kelly criterion, which will henceforth be referred

to as “Kelly”. The focus of each bet with a Kelly strategy shifts from optimising the expected value

of capital in each period to maximizing the expected value of capital growth. If the winnings from

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each bet are reinvested and the gambler retains autonomy over the gambling amount, then the

expected value of the logarithm of capital growth - exponential growth positively or negatively -

is accumulated by the gambler. By considering long term growth, the effects of repeated bets is

encompassed in the Kelly formula, thereby encompassing compounding wealth growth.

The Kelly strategy was soon adapted after Kelly’s initial publication, notably by Edward O. Thorp,

and introduced to other games such as blackjack, baccarat, and roulette - most notably blackjack,

where he first popularised the concept of using the Kelly criterion with strategies contained in his

book Beat the Dealer (1962). Unlike the original usage of Kelly in only one-to-one payoff games,

these games did not show such a characteristic and had much higher variation. The typical results

show that a gambler should limit the current maximum bet to a multiple of the minimum bet and

that bet sizes should be adjusted for changes in capital. In later study, Thorp (2008) further

elaborates the use of Kelly in arenas such as sports gambling. The study shows that sports bets are

independent, with the fraction needing to be invested as lower than that of a single bet. The formula

was later modified by Chu, Wu & Swartz (2018) in sports gambling where in determining the

optimal wagering fraction the unknown variable is the probability of placing a winning wager. A

loss function is introduced in order to estimate true Kelly and uses prior distributions as opposed

to frequency distributions. The results obtained show that the original Kelly formula is too volatile,

ergo risky, for most investors, and inconsistent while the modified Kelly led to a criterion based

on minimising expected prior loss and was more consistent.

Kelly has also been adapted and applied to stock markets, though with a requirement that the

discrete probabilities used in the gambling systems were changed to continuous probabilities

(Rotando & Thorp, 1992). Thorp (2008) noted that the situations in which a gambler and investor

operate are analogous and the Kelly criterion could be applied to both. In both cases, participants

aimed to achieve positive returns while incorporating risk into their decisions. This could be

potentially achieved by maximising the expected value of the logarithm of capital as in a Kelly

strategy. Chen & Huang (2008) noted that if investors aim to maximise the expected value of the

logarithm of capital, then they in fact possess logarithmic utility functions. Alternatively, Lo, Orr

& Zhang (2018) proved that if the investor follows expected utility theory, then Kelly is the optimal

strategy for these individuals, even with the inherent riskiness involved. As Kelly almost always

beats other approaches even in different portfolio scenarios, it can help investors allocate wealth

among different assets if adjusted for their level of risk utility. Investors often focus on the rate of

return on the capital they invested and how much their investment grows rather than the Sharpe

ratio of their investment (Estrada, 2009). This is generally the basis on which portfolio

performances are compared.

Utility theory plays a key role in finance, economics, and other fields alike. Expected utility theory

has a long history of use in developing the decision-making process when faced with uncertainty

(Eeckhoudt et al., 2005). The underlying assumptions are that the marginal utility of wealth is

linear but people experience diminishing marginal returns. Scholars for and against the school of

thought have jointly accepted it as the standard theory to use in comparison to other utility theories;

3

expected utility theory is theoretically sound, thereby making it a good basis for comparison. Some

utility functions, such as constant risk aversion (CARA) utility functions, face criticism about

assuming that the risk aversion of an investor does not decrease as wealth increases. However, an

argument can be made that CARA functions make for better comparisons between different assets

classes.

Kuznitz, Kandel & Fos (2008) and Nielsen (2014) further investigated the use of Kelly while

accommodating for the investor’s level of utility while rebalancing the returns gained. The need

for rebalancing is to ensure the original balance is maintained or a new proportion of investment

is made with the returns that were gained. Kuznitz, Kandel & Fos (2008) found that if transaction

costs were ignored, the investor should rebalance when returns are realised. On the contrary, when

transaction costs are involved, rebalancing should only occur on major realised returns or if partial

rebalancing can be used to reduce the impact of transaction costs. The benefit of partial rebalancing

was that it entailed a smoother setting due to its parameters being continuous while intermittent

rebalancing periods were integer based. In Nielsen’s (2014) study, he showed that for risk averse

individuals to optimise they would have to optimise on returns and the power utility function

(constant relative risk aversion). There exists an optimal strategy for investors to invest while

overcoming certain restrictions or constraints - stop-level. Power utility functions are based on two

assumptions (Eeckhoudt et al., 2005) - that the absolute risk aversion is decreasing but risk

aversion relative to level of wealth is constant. These functions negate income effects when an

investor must decide on the proportion of wealth to invest at different levels of wealth while

factoring in risk. This is analogous to the constant proportion of wealth required by the Kelly

Criterion and warrants its inclusion.

Davis & Leo (2011) and MacLean, Thorp & Ziemba (2011) argue the theory building the

foundation of the Kelly criterion is accepted as sound. However, the usage of the Kelly criterion

has not been supported by the majority of scholars and academic institutions due to factors such

as the inherently high level of risk involved (Estrada, 2009). As a result, the mean-variance

criterion is the commonly used and known method of portfolio optimization. The difference is that

Kelly maximizes the growth of the amount of capital invested while the mean-variance criterion

maximizes the expected excess return per unit of risk measured by volatility. In institutions, the

latter is taught with little to no mention made of Kelly (Estrada, 2009). Kelly has not been a popular

choice of theory due to some of its perceived shortcomings. A key assumption of the Kelly

criterion is the emergence of a market with investors that have logarithmic utility. Chen & Huang

(2008) argue that an investor that aims to maximize expected logarithmic utility is not a

conventional investor. However, they concurred that investors are still driven by the same

decisions, although the Kelly criterion for choosing the optimal portfolio has not yet been

established as valid. As there are infinitely many efficient portfolios, Markowitz does not help

identify which is best. Rotando & Thorp (1992), Markusson & Ohlsson (2017) and Chu, Wu &

Swartz (2018) argue that Kelly is highly risky due to the lack of diversification and the need to

heavily re-invest in a consistent asset class. Roll (1973) established that one would not be able to

4

distinguish between the cross-sectional relations of risk premiums and expected returns of the

Kelly Criterion and the Sharpe-Lintner model. His findings suggested that at the very least the

Kelly approach is comparable to the mean-variance approach. He also noted that if the goal of the

investor is to reach a certain terminal value of wealth and time is constant, then an argument for

the superiority of the Kelly Criterion can be made.

Estrada (2009) and Thorp (2011) argue that when certain criteria are met, the Kelly criterion is a

more plausible basis of optimizing portfolios. This contrasts with the more popular mean-variance

basis. The criteria Estrada (2009) proposed are that the investor is relatively less risk averse, the

investor is a long-term investor, and the investor both can and plans on maintaining their long

position holding period. The argument for this choice is that the Kelly Criterion portfolio

maximizes the geometric mean return while its more popular counterpart, the mean-variance

portfolio, maximises the arithmetic mean return. Since geometric better estimates returns when

focusing on the long-run, this would give an inherent advantage to the Kelly strategy. In addition,

when the performance of a portfolio is assessed, investors seldom look at portfolio performance

as a return per unit of risk. Instead the actual return from the portfolio is deemed to be a stronger

sign of performance. This gives more weight to the Kelly Criterion which maximizes growth and

in turn, maximizes returns. Rotando & Thorp (1992), Estrada (2009), Thorp (2011), MacLean et

al. (2011) and Markusson & Ohlsson (2017) all proved that the returns gained through Kelly

significantly outperformed traditional portfolios. In the same time frame, Kelly would be able to

achieve the same result as a traditional portfolios but at a shorter period. However, the optimal

returns gained are much more likely to occur over long-term periods. In the short run it is possible

for Kelly to perform evenly with or even significantly worse than traditional portfolios.

Kelly was first introduced using information theory and proven effective in gambling systems, and

only later was modified and adapted for potential use with investors. With cryptocurrencies

emerging as a relatively attractive new asset class for potential investor gain, further research can

be done in this area. In general, returns are weakly correlated between different cryptocurrencies

and other asset classes (Elendner et al., 2016). This enhances diversification opportunities for

investors. There is downside with cryptocurrency investment, such as high-risk volatility.

However, this can be said to be offset by high expected returns - making cryptocurrencies a

relatively unique asset class by modern standards. An investor who chooses to invest in

cryptocurrency also has the perk of transaction costs being much lower than that of the stock

market. Dyhrberg, Foley & Svec (2018) note that on the most common Bitcoin exchanges, for

instance, average transaction costs can range from 30 basis points to 100 basis points, which is

cheaper than is available with most brokers. Thus, more frequent rebalancing is potentially more

feasible, which could in turn enhance the growth rate of the investment.

The cryptocurrency market shows signs of high volatility, giving it a similar nature to gambling

whilst maintaining the characteristics of a stock market – in that it is traded on exchanges,

historical data is available, and probabilities are continuous (Jiang & Liang, 2017). Similar to that

of Rotando & Thorp (1992), Hagman (2014) and Markusson & Ohlsson (2017) where Kelly had

5

been used to compare returns against traditional portfolios, this paper shows how the difference in

full and partial Kellys can impact the returns of a portfolio while adjusting for an investor’s given

level of utility. Kelly will also be used in conjunction with the exponential utility function to assess

decisions investors would make when faced with investment decisions under uncertainty.

Comparison of the different results will give a clearer image of the type of investor that would

benefit most from use of the Kelly criterion. This paper does not aim to explain different utility

theories but rather, explain the impact they would have when applied to the Kelly criterion when

juxtaposed to the typical “half-Kelly” and “quarter-Kelly” strategies that tend to be used by current

investors as a theoretical way to mitigate inherent risk with the Kelly strategy. In this paper, we

will apply a Kelly and adjusted Kelly to a portfolio holding a cryptocurrency (specifically targeting

Bitcoin) and a safe offset, in this case 1-month US Treasury bills.

3.1 Methods

The traditional Kelly criterion uses an edge-over-odds calculation to determine the allocation an

investor should put into an asset. A Kelly strategy differs from most traditional strategies in that

it tends to be prone to larger exposure to risk while allocating much more of an investor’s wealth

into an asset according to MacLean, Thorp, and Ziemba (2011). Ohlsson and Markusson (2017)

use a Kelly Criterion based on Thorp’s (2006) approximation for a continuous distribution that

we will test for a comparison later in this paper using a risk-free rate and standard deviation

compared to regular returns.

This paper derives a modified Kelly criterion from a paper set forth by Chu, Wu, and Swartz

(2018) that offered a modified Kelly criterion that could be used in sports gambling. Their

proposed criterion was hence modified in order to fit an investment model rather than a gambling

model.

Consider the following. Given that the return of an asset from time period 0 to time period 1 is R,

an investor’s bankroll B1 at time period 1 is calculated assuming a desired Kelly fraction f of their

bankroll B0 at time period 0, as follows:

Where w is a binary variable that is 1 when an asset’s price increases in a given time period, and

0 when it decreases.

More simply, we can define Equation (2) as such:

6

Consider that especially for volatile investments such as cryptocurrencies, a breakdown of

potential investor return into two components might be desired since the empirical distribution

has both skewness and kurtosis that are not captured by an equal sized upward and downward

returns. As such, returns when price increases and returns when price decreases can be split into

two separate variables to measure the level of potential return when prices move in a given

direction. We can therefore amend Equation (3) to reflect this:

(4)

Now, consider that the ultimate goal for an investor is to maximize the growth in their wealth

over time. To achieve this, we can maximize the expected log growth of wealth over time for an

investor as follows:

𝐵1 (𝑓)

𝐸 [log ] = 𝐸[log((1 + 𝑅𝑈 𝑓)𝑤 (1 − 𝑅𝐷 𝑓)1−𝑤 )]

𝐵0

Where p is the probability of an increase in price during the given time period.

Differentiating Equation (5) with respect to f gives us:

𝑝𝑅𝑈 (1 − 𝑝)𝑅𝐷

− =0

1 + 𝑓𝑅𝑈 1 − 𝑓𝑅𝐷

Solving for f:

𝑝(𝑅𝑈 + 𝑅𝐷 ) − 𝑅𝐷

𝑓= (6)

𝑅𝑈 𝑅𝐷

Equation (6) gives another Kelly fraction that can be used to make investment decisions – in

other words, the proportion of an investor’s bankroll in time period n that will be invested until

time period n+1.

In this paper, this modified Kelly fraction is used to make investment decisions over different

investment horizons and using price, return, and empirical probability data calculated from

different periods of time. These results are reflected in the latter sections.

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For a comparison, we will use a version of a more traditional edge-over-odds Kelly as discussed

in Section 1. Ohlsson and Markusson (2017) propose a relatively simple strategy that is still

mathematically sound and thus will be used for comparison:

𝜇−𝑟

𝑓=

𝜎2 (7)

Where 𝜇 is the mean return, r is the risk-free rate, and 𝜎 2 is the variance of returns.

This paper also examines the usage of an exponential weighted moving average (EWMA) on the

empirical data used in the calculation of the Kelly fraction in order to check if the weighting of

more recent data is an effective strategy for investing in cryptocurrencies using the Kelly method

relative to an equal weighting of all available data. An EWMA is applied across data analysis,

often in finance, as a way to remove noise from data, it could be seen as having the potential to

work to an even greater extent in a newer market such as cryptocurrency. EWMA gives a level

of weighting to all previous data that decreases exponentially, which helps fulfill this removing

noise criterion. An example formula for EWMA, as provided by Raudys and Pabarškaitė (2018)

and used in this paper, can be defined as:

2

𝐸𝑊𝑀𝐴𝑛 (𝑋)𝑖 = 𝛼𝑋𝑖 + (1 − 𝛼)𝐸𝑊𝑀𝐴𝑛 (𝑋)𝑖−1 , where 𝛼 = .

𝑛+1

(8)

Where n is the window of days to be used as a test period for input data for the Kelly formula as

given in Equation (6) and 𝑋𝑖 is the mean of the given data to be tested.

Equation (6) is also tested relative to a strategy that maximized expected utility. Utility is not

commonly used in conjunction with Kelly strategies as there is still no consensus on multi-period

utility optimization. Typically, because Kelly is such a risky strategy, according to MacLean,

Thorp, and Ziemba (2011) many Kelly investors will use a “half-Kelly” or “quarter-Kelly” – i.e.,

calculate the Kelly strategy and halve or quarter it – as a methodology for controlling risk.

However, this method can be thought of as somewhat inadequate given the fact that it is

essentially a linear approximation for utility, and therefore just a risk-neutral assumption.

Therefore, using a proper utility function could potentially be a good approximation for allowing

for an investor’s risk appetite.

An exponential utility equation can be a good approximation for an investor’s required rate of

return given a level of risk appetite in this situation. Mercereau (2004) provides a simple

exponential utility equation, which allows closed-form solutions for potential levels of investor

utility:

−1 −𝐴𝑐

𝑢(𝑐) = 𝑒 (9)

𝐴

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Where A is a given level of risk tolerance, with values less than 0 representing those who are

risk-seeking and values more than 0 representing those who are risk-averse (risk-neutral

investors, with A of 0, can be ignored); and c representing the item that the utility equation is

seeking to maximise, in this case the growth of wealth over time. Equation (9) will be used to

solve for the Kelly fraction that on a given day maximizes an investor’s expected utility, thereby

yielding an approximate expected return that is more valuable for given levels of investor risk

appetite than just halving or quartering the Kelly result.

3.2 Data

The three cryptocurrencies used to test this modified Kelly criterion in Equation (6) relative to

other methods are Bitcoin, Ethereum, and Litecoin. Bitcoin is an obvious selection for anyone

testing investment in cryptocurrencies as it has by far the largest market cap, trading volume, and

general history of any available cryptocurrencies. Ethereum, as of writing, has the second largest

market cap among all cryptocurrencies and is significantly different enough from Bitcoin to yield

potentially different results due to differences such as its usage of smart contracts rather than a

peer-to-peer system. Ethereum also uses a proof-of-stake system for mining versus Bitcoin’s

proof-of-work, allowing for a higher chance of mining coins based on amount held rather than

just electricity usage. Cocco and Marchesi (2016) define mining as – for instance, relative to

Bitcoin – “a process in which the ‘proof-of-work’ validates a set of transactions and adds them to

the massive and transparent ledger of every past Bitcoin transaction… the generation of Bitcoins

is the reward for the validation process of the transactions.” Proof-of-stake may distort the

market in comparison, however, though Gui, Hortacsu & Tudon (2018) note that it also can

generally protect against attacks due to traceability, leaving some effective differences to

distinguish between the two for investors. Litecoin was an early spinoff of Bitcoin (a so-called

“altcoin”), and represents a coin that is technically effectively the same by technical standards;

however, it spun off early enough to have a large amount of data over time while representing a

significantly high enough market cap over the entire period to be properly differentiated from

Bitcoin.

All cryptocurrency data used is reflected in closing prices – but since trading of cryptocurrencies

technically does not stop at any time, closing prices are defined as the cryptocurrency’s price at

23:59 UTC. Closing prices are used as the smallest time window of investment we assume is an

investment once per day. All cryptocurrency prices are taken from coinmarketcap.com. Data for

daily 1-month US T-Bill yields used in testing of an alternate edge-over-odds Kelly Criterion are

taken from the St. Louis Fed.

4. Results

In this analysis of results, a comparison between different Kelly criteria are used. First, we

compare returns of the modified Kelly derived in Equation (6) to a more traditional edge-over-

odds Kelly and a passive strategy in which the investor buys the cryptocurrency at the beginning

of the tested period and holds until the end. In order to reflect the effects of different rebalancing

9

periods and different sampling period of the empirical distribution, a breakdown of the modified

Kelly into different trading periods – daily, every second day, weekly, and biweekly – as well as

exponentially weighted moving average periods – 7-day, 30-day, 60-day and 90-day - is

depicted. Since many financial models assume that the prices of more recent data are more

relevant, the estimations from the empirical data are then weighted and adjusted to place more

emphasis on recent data. Furthermore, short selling is included into the aforementioned versions

of the modified Kelly tests to allow for a more generalized test of the strategy. The use of short

selling is a possible option for investors in the crypto space, at least for the cryptocurrencies

tested in this paper. Even though all tested cryptocurrencies have increased significantly over

time, there are incredibly bearish periods in which investors may be able to take advantage of a

downswing quickly before moving out of the position. In addition, exponential utility is tested to

see if an alternative to the typical linear strategies that lower risk from a Kelly investment is

feasible in the context of the Modified Kelly set out in this paper.

It should be noted that the following analysis included the following assumptions:

The investment window used is 1 April 2017 to 31 August 2018, though other potential

windows are included in one part of the section. This is a relatively short period to test for

a Kelly strategy due to the general aim to maximise long-term capital growth but since

cryptocurrency markets have been relatively underdeveloped until recently – for instance,

Ethereum was only founded in mid-2015 - this period is the only where there is data for

all the cryptocurrencies in consideration while leaving enough data for the estimation of

the empirical distribution. It should also be noted that this investment period incorporates

a “pre-boom” period (approximately from April 2017 until November 2017), the “boom”

period (approximately December 2017), and the “post-boom” period (approximately

January 2018-present), as will be referred to later in this paper.

The values for probability of a positive return and the values for the predicted up-return

and down-returns were estimated using the empirical distribution. The number of

historical days used depended on the given strategy.

We assume no transaction costs. This includes all fees which would be included in

transferring funds from platform to platform and the fees charged for short selling, as

well as taxes.

This study does not include leveraging. Therefore, when a Kelly allocation indicates that

an investor should use an allocation in the tested asset of greater than one, which

indicates that the investor should take on leverage in order to maximise long-terms

returns, it is capped at one.

When the Kelly fraction is less than one, it is assumed that the investor holds their

remaining wealth as cash rather than investing in a risk-free asset due to the negligible

impact this has on comparative returns.

10

When short selling was not used, if the Kelly fraction was less than zero it was capped at

zero; if short selling was used, if the Kelly fraction was less than -1 it was capped at -1 to

ensure the lack of leverage trading.

It is assumed that all investment decisions and subsequent investments are made at 23:59

UTC once the “closing price” data for the day becomes available. All transactions are

done through an exchange from US Dollars to cryptocurrency or vice versa.

It is generally assumed for the purposes of this paper that any given potential Kelly

investor, to some extent, is risk-seeking, though this does not necessarily have to be the

case. Many of the recommended strategies that would maximise investor wealth are

inherently very risky – sometimes requiring a 100% investment in only one asset – and

investors who are risk-averse are unlikely to be willing to commit to such a strategy.

4.1 Analysis of the Modified Kelly versus Traditional Kelly and Passive

The strategies were compared over the time period 1 April 2017 to 31 August 2018, henceforth

referred to as the “Main Time Period.” The Modified Kelly strategy calculates the appropriate

allocation of wealth based off of three variables – the probability of the price increasing, returns

when prices increased, and returns when prices decreased. The investment is assumed to be

rebalanced daily to ensure returns are optimised. The traditional Kelly, as shown in Equation (7),

differs in investment allocation as it uses an edge-over-odds approach. Both strategies use

historical empirical data to infer conclusions as to how current decisions should be made. Both

strategies are additionally compared to the benchmark which is a passive buy-and-hold strategy.

The following is an illustration of the methodology used for each strategy.

On 1 April 2017, the investor starts with an initial capital of $1000. Using all of the historical

data prior to 1 April 2017, we estimate the required parameters for each of the strategies and

calculate the associated fraction the investor would allocate to the strategy. We then move the

clock forward and calculate the wealth an investor would have based on the change in price of

the underlying cryptocurrency on 2 April 2017. The process is then repeated to calculate the new

fraction an investor should allocate to each strategy using all of the data prior to 2 April 2017.

The whole process is repeated until the clock reaches the final date of 31 August 2018.

Table 1 provides a summary of the overall returns generated over the time period 1 April 2017 to

31 August 2018.

1/04/2017 - 31/08/2018

Modified Traditional Passive

Kelly Kelly Investment

11

Bitcoin 551,33% 0,44% 551,33%

Ethereum 458,19% 743,00% 458,19%

Litecoin 800,15% 226,02% 800,15%

The results do not follow a similar trend to prior studies where Kelly strategies outperforms the

passive investment strategy. The overall returns generated using the modified Kelly are the same

as the passive investment strategy because the Kelly allocation in the modified strategy suggests

to the investors to invest their entire wealth in each cryptocurrency for every day over the period,

effectively acting the same as a passive strategy would. However, it should be noted that the

recommended Kelly allocation for both Bitcoin and Litecoin began higher but continued a

downward trend towards the end of the period, suggesting that as more data is accumulated a

more realistic Kelly allocation not investing full wealth into the asset may occur – but more

research is likely needed. It can be reasonably assumed that the allocation would normalise over

time as the market for cryptocurrencies begins trending more towards a less volatile distribution

as has occurred in recent months. Additionally, both Modified Kelly and the passive strategy

perform better than Traditional Kelly with the exception of Ethereum. This is potentially an

anomaly due to Ethereum having less available prior data than the other two coins.

In this section, the effects of rebalancing periods on the modified Kelly investment on the Kelly

portfolio are tested by rebalancing every second day, weekly, and biweekly periods. Investing

through these periods would reduce the amount of times rebalancing would occur which does

have the benefit of ultimately reducing transaction costs. The Main Time Period was also used

for this portion of study, but precise starting and ending dates may vary based on necessity

within the time period; for instance, the biweekly trading period ends on 22 August 2018 as the

next possible trading date falls outside of the Main Time Period. The methodology illustrated

above is the same methodology employed in this section, but in each step the clock is moved

forward by the appropriate rebalancing period.

The mean and the standard deviation in Table 2 represent the daily mean and volatility of the

experienced returns for each of the strategies. A Sharpe ratio was also included to show

comparative risk-adjusted returns.

Table 2 Descriptive Statistics for different trading periods

1/04/2017 - 31/08/2018

Daily Alternate Day Weekly Biweekly

Bitcoin

Total Return 551,33% 545,83% 176,86% 176,86%

Mean 0,48% 1,00% 1,39% 4,73%

Standard Deviation 4,95% 7,54% 13,94% 20,18%

Sharpe Ratio 111,29% 72,36% 12,69% 8,76%

12

Ethereum

Total Return 458,19% 460,37% 451,58% 483,45%

Mean 0,53% 1,12% 4,06% 8,89%

Standard Deviation 6,42% 9,70% 19,28% 30,93%

Sharpe Ratio 71,30% 47,47% 23,42% 15,63%

Litecoin

Total Return 800,15% 776,74% 483,77% 732,56%

Mean 0,71% 1,40% 4,61% 10,85%

Standard Deviation 7,76% 10,93% 22,97% 33,90%

Sharpe Ratio 103,11% 71,08% 21,07% 21,61%

As per Table 2, all investment strategies involving daily trading outperforms the alternate

strategies except for Ethereum where investing in alternate days and biweekly outperform. This

outperformance in Ethereum is the result of the periods optimising price changes and volatility –

more days with large price gains. This is then classified as an anomaly as the trading period is

decided by the investor and will not always be able to optimise on upward price trends. While

biweekly returns may be higher occasionally, it is also consistently the strategy that exposes the

investor to the most volatility. Bitcoin and Litecoin give optimal returns regardless of risk

adjustments if an investor follows a daily trading period.

The Sharpe ratio is used to adjust the returns for risk exposure. The Sharpe ratio was calculated

by taking the mean returns, subtracting the risk-free rate (the average yield of US 1-month T-

Bills over the Main Time Period) then dividing the difference by the standard deviation. For

Bitcoin and Litecoin, it is confirmed that investors should use a daily trading strategy for the

highest returns, though this was inherently obvious due to this strategy containing the highest

mean and lowest standard deviation amongst strategies. On the other hand, even though the total

returns would suggest that an investor implement the biweekly strategy when investing in

Ethereum, the Sharpe ratio also concludes that the best time period to use should be the Daily.

Therefore, for the remainder of the study a daily investment period will be used.

The estimation of the parameters for each of the Kelly fractions (equations 6) are calculated from

the empirical distribution. In order to improve the quality of the estimated parameters, we

examine the use of an exponentially weighted moving average on each of the input data streams.

Therefore to obtain a value of f for each time period, the exponentially moving average formula

(Equation 8) was applied to each of the inputs of Equation 6. It is worth noting that from

equation 8, α is the level of weighting of the most recent data. As α = 2 / n+1, it decreases in

magnitude as the time period, n, increases.

days, 60 days and 90 days. A shorter weighting period is in general a more reactionary strategy.

Recent data is factored in more quickly and weighted more heavily compared to the average of

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the previous data, and thus investment decisions are more in line with the most recent market

sentiment. It is easy to see the potential of this strategy, therefore, in more volatile markets such

as cryptocurrency markets, especially when bullish and bearish trends are common, as “riding

the wave” has the potential to lead to larger success.

The following charts illustrate the returns achieved by the strategy using the different weighting

periods for each of the different cryptocurrencies.

Figure 1 is a plot of the cumulative returns of Bitcoin. The results showed total cumulative

returns of 10232,37%, 2119,44%, 1250,69% and 876,78% for the 7-day, 30-day, 60-day and 90-

day periods respectively. The 7-day period had the largest cumulative return and it was traded

throughout the period due to larger fluctuations in data from which the Kelly fraction was

calculated. Due to the larger α of 0.25, opportunities to benefit from the short term bullish and

bearish trends that have tended to happen with Bitcoin – though mainly bullish – tend to occur

more frequently. The 30-day and 60-day periods as shown have a lower α and require a longer

bullish market run to recommend any significant allocation in Bitcoin. When this requirement

was not met, the Kelly fraction decreased to zero, the investment strategy became hold and

cumulative returns were capped. The 30-day period had a higher cumulative return than the 60-

day return which in turn had a higher cumulative return than the 90-day period with α90 – the

window with the lowest cumulative return due to the longest overall recommend periods of

holding.

Fig. 2 Ethereum: EWMA Cumulative Returns

14

Figure 2 is a plot of the percentage cumulative returns of Ethereum using EWMA. The results

showed a cumulative return of 27758,80%, 6197,83%, 1458,37% and 1666,98% for the 7-day,

30-day, 60-day and 90-day periods respectively. The 7-day period also continued to trade

throughout the period for reason similar to those of the 7-day period of Bitcoin in that the

volatility in data inputs contributed to wild swings in recommended Kelly allocations. The

results generally followed the general trend followed by Bitcoin EWMA cumulative returns with

the 30-day period generating the second highest returns while also switching between trade and

hold strategies depending on the length of the historic bullish run in the market. In the case of

Ethereum the 90-day cumulative returns were higher than the 60-day returns; however, this can

be chalked up to luck due to the relatively small difference between the two returns.

As was the case with Bitcoin, all the periods using exponentially weighted moving average

maximise the possible daily return and cap the maximum losses. Maximum returns across daily

returns due to price change was 33,66% and while 60-day and 90-day periods held maximum

losses of 22,81%, the 7-day and 30-day periods capped them to 17,81% and 18,44%

respectively.

The mean daily returns for the 7-day, 30-day, 60-day and 90-day period of Ethereum were

1,21%, 0,92%, 0,69% and 0,71% respectively, as compared to 0,53% from strictly holding. The

weighted average strategy across all periods outperformed the same strategy relative to Bitcoin

on average, though this can be partially attributed to Ethereum seeing a larger percentage

increase in price over the Main Time Period. Once again, the 7-day window for EWMA held the

largest returns and lowest standard deviation.

Fig. 3 Litecoin: EWMA Cumulative Returns

15

Figure 3 is a plot of the cumulative returns of Litecoin. Like Ethereum, Litecoin was in general

more volatile than Bitcoin over the Main Time Period. The results were similar to the Ethereum

results. The cumulative return for the 7-day, 30-day, 60-day and 90-day period were 31790,77%,

7007,76%, 2233,48% and 3010,30% respectively. The relative performance of returns was also

similar to those of Ethereum and the general extra risk from the increase in volatility was

compensated through increase in returns. It should be noted that since the 90-day window

outperformed the 60-day window in returns for both Ethereum and Litecoin, which are in general

more volatile, that the 90-day window can be said to be preferable for more volatile

cryptocurrencies.

As was the case with Ethereum and Bitcoin, all the periods using exponentially weighted moving

average maximise the possible daily return and cap the maximum losses. Maximum return across

daily returns was 47,60% and while 60-day and 90-day periods had maximum loss of 32,64%,

the same as the maximum loss due to price change, the 7-day and 30-day periods capped them to

15,14% and 29,60% respectively. This finding is once again significant in favor of the 7-day

window; the potential ruin is capped significantly in an even more volatile market than Bitcoin.

The average daily return for the 7-day, 30-day, 60-day and 90-day mean for the daily returns of

Litecoin were 1,30%, 1,04%, 0,83% and 0,91% respectively, as compared to a 0,73% return

from strictly holding. The weighted average strategy across all periods outperformed the holding

Bitcoin on average. The standard deviation for the same periods for Kelly daily returns were

6,33%, 6,85%, 6,84% and 7,22% which was lower than that of the daily price returns of 7,76%.

16

Table 3 Rolling Moving Average Returns

1/04/2017 - 31/08/2018

Returns – No short selling

7 Day (%) 30 Day (%) 60 Day (%) 90 Day (%)

Bitcoin 27329.48 2396.44 1359.70 900.33

Ethereum 13080.31 11517.75 10322.27 10322.27

Litecoin 100725.97 7689.94 2325.16 3021.87

7 Day (%) 30 Day (%) 60 Day (%) 90 Day (%)

Bitcoin 86805,04 5657,75 1625,56 978,20

Ethereum 842315,25 37757,15 3913,27 3366,10

Litecoin 267401,52 28637,33 4361,37 6625,78

Table 3 then shows the descriptive statistic of the daily returns of price and for each of the

exponentially weighted moving averages. The daily return for price is the percentage increase or

decrease in price from the price of the prior day. The daily return is the percentage increase in

wealth using the specific weighting period model. The output was obtained through data analysis

tools in Excel.

Table 4 EWMA Descriptive Statistics – No Short Selling

Bitcoin - Regular

Price (%) 7 Day (%) 30 Day (%) 60 Day (%) 90 Day (%)

Ethereum - Regular

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Price (%) 7 Day (%) 30 Day (%) 60 Day (%) 90 Day (%)

Litecoin - Regular

Price (%) 7 Day (%) 30 Day (%) 60 Day (%) 90 Day (%)

All the periods in Table 4 tend towards the largest possible daily return. This is because when

market sentiment is bullish – the Kelly fraction trends towards 1; and the increase in the portfolio

is close to or exactly one-to-one with the increase in the price of the underlying. Thus, the

maximum daily return experienced in the period by the price and across all weighting periods

was 25,25%. Another added benefit is that when market sentiment is bearish, the Kelly fraction

tends to decrease towards and past -1. This lowers the percentage of the portfolio invested and

minimizes potential ruin from a decrease in the price of the underlying. While 60-day and 90-

days periods had a maximum loss of 18,74%, the 7-day and 30-day periods capped losses at

8,78% and 18,26% respectively. This is obviously much more notable for the 7-day window, and

potentially significant in terms of minimising relative potential investor ruin.

18

To gain a better understanding of the performance of the exponentially weighted moving average

portfolios, the return relative to risk was also considered. From table 3, the mean daily returns for

the 7-day, 30-day, 60-day, and 90-day windows for Bitcoin were 1,15%, 0,70%, 0,60%, and

0,53% respectively, as opposed to 0,48% from strictly holding. The weighted average strategy

across all weighting periods outperformed the holding Bitcoin on average. The standard

deviation for the same periods was 3,60%, 3,97%, 3,94% and 4,09% for the 7-day, 30-day, 60-

day and 90-day periods. The standard deviation across all the weighted periods is less than that

of the daily price returns, 4,95%, across all weighting periods, a positive sign for the mitigating

risk factor of the strategy. The 7-day window also outperforms all others in this aspect with the

highest returns and lowest volatility.

These findings indicate that a 7-day window used in conjunction with an exponentially weighted

moving average may be a significant way to generate outperforming returns for investors.

Among all versions of the strategy tested and as compared to the benchmark, the 7-day window

EWMA consistently generated the highest mean and cumulative returns, both daily and total,

while also having the lowest volatility and capping potential investor ruin much more

significantly than any of the other strategies.

When short selling is taken into account (see Table 5) potential investor returns increase

significantly, especially in regard to the 7-day window. For the 7-day window, potential investor

returns increase 9-fold for Bitcoin, and this is on the low end; potential investor returns for

Litecoin increase 11-fold and for Ethereum the increase is 25-fold. There are somewhat

significant increases for the 30-day window, the 60-day window sees smaller increases, and the

90-day windows sees increases for Ethereum and Litecoin but a decrease in Bitcoin; this might

be due to the lower overall allocation the Modified Kelly would suggest in Bitcoin during

segments of the rolling window.

This continues to support a 7-day rolling window as a potential investment strategy. Although

shorting is somewhat difficult for non-Bitcoin cryptocurrencies at present moment, taking into

account recent information seems to boost significantly potential returns; booms and busts are

effectively taken advantage of, even outside of the December-January boom-bust period that

increases the seeming potentially incredible returns shown. The downside protection that the 7-

day window provides also continues to be evident.

Bitcoin - with Short selling

Rolling window in days 1/04/2017 - 31/08/2018

Price (%) 7 Day (%) 30 Day (%) 60 Day (%) 90 Day (%)

Overall Return 551,33% 86805,04% 5657,75% 1625,56% 978,20%

Mean 0,48% 1,42% 0,90% 0,66% 0,57%

Standard Deviation 4,95% 4,62% 4,70% 4,71% 4,66%

Max 25,25% 25,25% 25,25% 25,25% 25,25%

Min -18,74% -15,40% -18,27% -18,74% -18,74%

19

Skewness 0,38 0,61 0,72 0,60 0,53

Kurtosis 3,13 3,67 3,69 3,73 4,02

Sharpe Ratio 102,78% 19454,41% 1099,89% 309,44% 130,86%

Ethereum - with Short selling

Rolling window in days

Price (%) 7 Day (%) 30 Day (%) 60 Day (%) 90 Day (%)

Overall Return 458,19% 842312,25% 37757,15% 3913,27% 3366,18%

Mean 0,53% 1,94% 1,32% 0,90% 0,88%

Standard Deviation 6,42% 5,99% 5,84% 6,14% 6,34%

Max 33,66% 33,66% 33,66% 33,66% 33,66%

Min -22,81% -17,81% -18,44% -22,81% -22,81%

Skewness 0,75 0,82 0,84 0,86 0,73

Kurtosis 3,11 3,23 3,60 3,70 3,17

Sharpe Ratio 64,67% 114148,25% 4829,35% 485,80% 538,36%

Litecoin - with Short selling

Rolling window in days

Price (%) 7 Day (%) 30 Day (%) 60 Day (%) 90 Day (%)

Overall Return 800,15% 267401,52% 28637,33% 4361,37% 6625,78%

Mean 0,71% 1,79% 1,36% 0,99% 1,09%

Standard Deviation 7,76% 7,38% 7,47% 7,33% 7,68%

Max 47,60% 47,60% 47,60% 47,60% 47,60%

Min -32,64% -21,97% -29,60% -32,64% -32,64%

Skewness 1,47 1,74 1,49 1,50 1,43

Kurtosis 6,92 7,58 7,57 8,11 6,99

Sharpe Ratio 97,56% 50371,14% 4553,60% 324,27% 926,42%

In this instance the fraction of the investor’s wealth to invest in the different cryptocurrencies is

determined by maximizing their expected utility. Utility in this case is an exponential utility as

defined in Equation (9) with different risk aversion parameters. Since the actual investor’s risk

aversion parameter is unknown, we estimate the efficient frontier by using 5 equally spaced risk

aversion parameters i.e. 1, 0.5, 0.25, -0.25, -0.5 and -1.0.

The following is an illustration of the methodology used for this strategy:

On 1 April 2017, the investor starts with an initial capital of $1000. Given a risk aversion

parameter and an investment horizon, we maximise the investor’s expected utility. The expected

utility is calculated using Monte Carlo simulation that randomly selects a date prior to 1 April

2017 minus the investment horizon. For example, if the investment horizon is 20 days then the

dates selected would occur prior to 11 March 2017. For the chosen date, the utility is calculated

using Equation (9) where the risk aversion parameter is given and the terminal wealth is

calculated using the return from the selected date to the selected date plus the investment

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horizon. In order to ensure convergence of the mean utility, we randomly simulate 20000 dates

with replacement. The maximization is performed by stepping over all fractional investments

from 0% to 100% in steps of 1% and simulating the expected utility for each fraction. The

fraction that maximises the expected utility is then used as the investment fraction for 1 April

2017. The clock is then moved forward, and the wealth an investor would have based on the

change in price of the underlying cryptocurrency on 2 April 2017 is calculated. The process is

then repeated to calculate the new fraction an investor should allocate to the strategy using all of

the data prior to 2 April 2017 minus the investment horizon. The whole process is repeated until

the clock reaches the final date of 31 August 2018.

The above process is then repeated 5 separate times at the same risk aversion parameter and

investment horizon to check for stability of this method and ensure that the outcomes are

consistent. If the percent change in the outcomes is too large, then we can conclude that

maximising expected utility is too sensitive to the input parameters and therefore not a viable

investment methodology for cryptocurrencies.

Finally, all of the above processes are performed for each of the 5 risk aversion parameters.

It should be noted that Bitcoin and Litecoin had 1952 total price data points available and

Ethereum had 1121 total price data points available.

Bitcoin

-1 548,68% 0,48% 4,94%

-0.5 548,04% 0,48% 4,93%

-0.25 547,42% 0.48% 4.93%

0.25 0,00% 0,00% 0,00%

0.5 0,00% 0,00% 0,00%

1 0,00% 0,00% 0,00%

Ethereum

-1 457,24% 0,53% 6,42%

-0.5 456,65% 0,53% 6,42%

-0.25 456,14% 0,53% 6,41%

0.25 0,00% 0,00% 0,00%

0.5 0,00% 0,00% 0,00%

1 0,00% 0,00% 0,00%

Litecoin

-1 2122,75% 0,82% 6,90%

-0.5 791,07% 0,71% 7,75%

-0.25 789,46% 0,71% 7,75%

0.25 59,38% 0,09% 0,75%

0.5 30,50% 0,05% 0,44%

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1 12,30% 0,02% 0,24%

Using an investment horizon of 30 days, the results for each of the risk aversion parameters for

each of the cryptocurrencies is listed in Table 5. Comparing these strategies to the passive

strategy, Litecoin for investors with a risk tolerance of -1 i.e. risk seeking showed the only major

outperformance with a 2122,75% return for the Main Time Period compared to the 800,15%

achieved over the period for the passive strategy. Otherwise, returns ranged from barely

outperforming a passive strategy to significant underperformance. Risk averse investors for

Bitcoin and Ethereum also were calculated as gaining 0 utility from betting on price movements

and as such did not gain any returns. Overall, this strategy did not show much outperformance

through utility outside of significantly risk-seeking investors in Litecoin.

However, since the distribution of the sample mean utility should have an error proportional to

1/√20000, we would expect the resulting terminal wealth to be approximately the same. The

results approximately converge at a 2% tolerance level (see further trials undertaken to prove

convergence in Appendix A). This proves that to some extent, an exponential utility may be a

viable risk dampener that helps investors pick an appropriate Kelly allocation as opposed to

halving or quartering a resulting Kelly fraction. However, it is prudent to conclude that

maximizing expected utility for crytpocurrencies is likely not an incredibly tenable strategy

when, outside of Litecoin investors who are extremely risk-seeking, final wealth levels are

mostly comparable to investors who undertake a passive strategy and frequent rebalancing of the

portfolio, thereby incurring significant transaction costs, is required to undertake this utility

strategy.

One major contrast is that a Kelly strategy is more useful as a multi-period model whereas utility

is more of a single-period model. When seeking to maximise expected utility, the investor cares

only about immediate growth in the short-term, whereas when executing a Kelly strategy the

investor seeks to maximise long-term expected growth of their wealth. Therefore, it is possible

that the two strategies cannot fully coalesce, partially explaining the overall lackluster return

outcomes shown in Table 6.

5. Discussion

The cryptocurrency market is a new and emerging market where, now that the market boom of

December 2017 has passed and the market seems to have begun to normalize, investors may be

able to take advantage of a stable yet higher volatility market. The results clearly show that

capital invested in the cryptocurrency market, irrespective of strategy, will have produced high

return over time assuming an investor was willing to take on some level of additional risk. There

are potential further decisions to be made – with the recommended Kelly allocation often larger

22

than 1 or lower than -1, the investor would theoretically maximize the growth of their log wealth

through short selling or taking on leverage, and with the restrictions undertaken in this study,

there is potential for even larger returns for the investor willing to take on further risk than has

already been recommended. The key finding in this paper were the monumental returns that were

generated using a 7-day rolling period with exponentially weighted moving averages, including

short-selling. The modified Kelly adapted to all of the rolling periods, but most specifically the

7-day window, with this window having significantly higher returns and lower volatility and

potential ruin than what would be available either from holding in the cryptocurrency market or

holding in a regular market such as the S&P 500 (for comparison’s sake, the growth of a typical

S&P ETF over the Main Time Period was approximately 27%). Short selling would be

recommended if an investor can afford the significant extra burden of the transaction costs that

would be involved in a daily rebalancing of a shorted cryptocurrency portfolio. Leverage is

another method investors could use to unlock greater returns – especially with the often bullish

trends that cryptocurrency markets have experienced, a quick leverage in an uptick period could

result in greatly magnified returns. Finally, the exponential utility function was used to adjust

potential investor returns with respect to their level of risk tolerance. Generally, the more willing

the investor is willing to take on risk, the more returns could be expected from the market,

although in most cases with usage of the exponential utility function the returns are likely not

worth the constant

This paper discusses the use of Kelly in a cryptocurrency market and the utility that an investor

will derive. In general, prior applications of Kelly criteria have focused on gambling, sports

betting, and stock markets. As mentioned earlier, cryptocurrencies are a relatively new market

that tend to promise investors high returns, though over the past few months the market has

become more normalized while still containing significant volatility. This paper proposes that

using a modified Kelly adapted to the optimal rolling period of 7-days with exponentially

weighted moving averages is the best method to outperform a passive strategy in the

cryptocurrency market. The 7-day window is ultimately most optimal as it offers investors

enough flexibility to take advantage of immediate price fluctuations while the tested other

periods, due to the time duration, are less flexible. The 7-day window also contains enough data

to feel comfortable accepting that a trend is occurring as compared to even smaller potential

windows, which may not contain enough data to establish a trend – or may bypass enough data

points to miss a trend. Essentially, the 7-day rolling period allows the investor to make the most

optimal prediction in the market, while even offering a much lower volatility and potential ruin.

However, even while the 60-day and 90-day may offer returns which are comparably lower to

the other rolling periods, they are still higher than those achieved through a passive investment

strategy – but since the 7-day window is more optimal in every conceivable way than the other

tested windows, it is the only one that can be recommended as an option. It can be theorised that

in general this is due to the nature of the cryptocurrency market up until the present.

Cryptocurrency investors have likely reacted more quickly to new information than the average

investor, and while not necessarily creating an efficient market, it rather creates a market that

23

was much more prone to bullish and bearish trends over shorter periods of time; investors in the

cryptocurrency market have also tended to be more price elastic, which has led to more

overreaction than in a normal market which contributes towards the relative volatility in the

market; a 7-day window is likeliest to take this information into account most effectively as it

can quickly identify when a bull market is occurring and update efficiently, while also

significantly lowering the recommended allocation once the market begins turning more bearish.

The general Modified Kelly strategy offers returns which at present are the same as those earned

through a passive strategy – as it essentially morphs into a passive strategy through always

recommending a full allocation into the asset. As the recommended Kelly allocation continues to

decrease for all cryptocurrencies, trending towards a 1 and potentially lower allocation, more

data may contribute to a more robust trading strategy that can be utilised with this method, but

more data will need to be accumulated first. This suggests that more data is necessary over

longer durations. As MacLean, Thorp, and Ziemba (2011) note, Kelly is a long-term growth

optimisation strategy and is most useful when considered over an infinite period. Therefore,

readers should be aware that the results obtained in this study are focused heavily around the

single market boom and bust, which may be considered an anomaly in the long-term purview of

the cryptocurrency market. With more extensive data, especially if the market begins to

normalise relative to its previous constant bullish states, Kelly recommendations for allocation

should begin to recommend an allocation of less than 1 and as a result may alter wealth

allocations into fractions and not recommend investing fully in the asset over the entire period.

There are three factors which have been neglected but would alter returns had they been included

in this study – taxes, transaction costs, and leveraging. As cryptocurrencies have generally been

classified as an asset by governments, the returns gained can incur capital gains taxes. In this

study, because the asset in consideration is cryptocurrency, the transactions costs associated with

them is relatively lower. However, this may not be the case because the Modified Kelly using

rolling periods with expected weighted moving averages suggests a daily rebalancing of the

portfolio and trades would be initiated daily. These transaction costs, although notably minimal

on a relative basis (between 30 and 100 basis points per trade according to Gui, Hortacsu &

Tudon (2018)) would tend to accumulate and reduce the amount of returns generated. It is

believed that leveraging would be likely to amplify returns significantly. In this study, there were

multiple instances where a return was made and the Kelly fraction suggested an allocation

greater than 1, but the bounds of the study capped the Kelly allocation to 1. This implies

investors could have gained returns through leveraging, but with the changes in the market that

have been occurring, would be a mistake to recommend significant frequent leveraging until

more trends in the post-boom cryptocurrency market come to light.

Finally, each investor has his/her own risk tolerance level with which they are willing to engage

in before avoiding an investment. This study demonstrates that instead of following the full

modified Kelly using a 7-day rolling period with exponential weighted moving average, the

investor can optimise the growth of their wealth, through optimising their utility. Exponential

24

utility as tested in this study is not recommended for investor usage for mitigation of risk due to

the lack of convergence in results; while half-Kelly and quarter-Kelly strategies along with other

similar linear risk mitigating strategies that are used by relatively more risk-averse investors are

certainly not fully adequate to approximate what proportion of a recommended Kelly allocation

should be invested in order to mitigate enough risk while still maximizing return, they may be

the best strategies currently available for those investors who still wish to utilise a Kelly strategy

to some extent.

As the cryptocurrency market expands and develops, there are numerous opportunities for

investors to apply different strategies and profit off of trends in the market. This paper focused

mainly on the modified Kelly using rolling windows along with exponentially weighted moving

averages while including short selling if it increased potential to magnify returns. An exponential

utility was tested, but ultimately failed as an airtight way to mitigate for potential Kelly investors

who may be more risk-averse, and even mostly for those who are more risk-seeking especially

relative to risk-adjusted returns available from 7-day EWMA windows. Thus, future research

could expand on comparing Kelly to different strategies in the cryptocurrency market, perhaps

attempting to use another relevant utility function to mitigate investor risk or trying to

incorporate leveraging. Furthermore, a more practical concise analysis of transaction costs and

how it would affect returns is an area that could be explored as many studies, including this one,

ignore transaction costs in their assumptions. Ultimately, the best way to incorporate a Kelly

strategy into the market might be to wait for more data to become available in the newer, more

normalised market and continuing to re-test along the lines used in this paper.

6. Conclusion

This paper aimed to establish whether a Kelly criterion relevant to the cryptocurrency market

could be developed, and if so, in what way it could be most applied to the market to maximise

the growth of investor wealth over time.

A Traditional Kelly criterion and Modified Kelly criterion were applied to Bitcoin, Ethereum and

Litecoin and compared against a benchmark, a passive srategy of buying and holding the

underlying cryptocurrencies. By applying exponentially weighting moving averages for a 7-day,

30-day, 60-day and 90-day period, the resulting Kelly portfolios consistently outperformed the

passive strategy. It could then be concluded that there is value to be added from an active Kelly

strategy. The tendency for shorter weighting periods to outperform longer weighting periods

showed that for an investor to maximise their wealth over time, then quick reaction to market

sentiment is necessary. The Kelly fraction was also capped at 1 so the effects of gearing could

not be tested. For risk seeking investors further studies into this might be of value. Allowing for

short selling produced mixed results. It can then be concluded that access to short selling markets

is not a necessary part of maximizing wealth growth. The omission of transaction costs means

that returns were overstated. However, looking at the 7-day exponentially weighted moving

average portfolio, the level of outperformance warrants the extra costs of daily rebalancing.

25

Utility relative to half-and-quarterKelly

Novel approaches (EWMA + modified Kelly)

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