polymarket-skills/polymarket-strategy-advisor/references/decision-framework.md

Decision Framework for Prediction Market Trading

A complete, rule-based decision tree for entries, exits, position sizing, and risk management. Follow these rules mechanically -- discretionary overrides are the primary source of losses for prediction market traders.

Entry Decision Tree

START: Market candidate identified
  |
  v
[1] Volume > $10K/24h? ----NO----> SKIP (illiquid)
  |YES
  v
[2] Spread < 10%? ----NO----> SKIP (too expensive to enter/exit)
  |YES
  v
[3] End date > 24h away? ----NO----> SKIP (near-resolution, efficiently priced)
  |YES
  v
[4] Accepting orders? ----NO----> SKIP (book closed)
  |YES
  v
[5] Can you classify the edge? ----NO----> SKIP (no edge = no trade)
  |YES
  v
[6] Edge > 5% (after fees)? ----NO----> SKIP (insufficient edge)
  |YES
  v
[7] Kelly size > 0? ----NO----> SKIP (negative EV by your own model)
  |YES
  v
[8] Risk rules pass? ----NO----> SKIP (risk limit reached)
  |YES
  v
TRADE

Every "SKIP" must be logged with the specific reason. This creates a record for later review of whether your filters are too tight or too loose.

Position Sizing Rules

Kelly Criterion (Half-Kelly)

The Kelly criterion calculates the mathematically optimal bet size to maximize long-term growth:

Full Kelly fraction = (p * b - q) / b

Where:
  p = your estimated probability of winning
  q = 1 - p (probability of losing)
  b = odds received (payout / risk)

For binary prediction markets:
  b = (1 - entry_price) / entry_price  (for YES bets)
  b = entry_price / (1 - entry_price)  (for NO bets)

Half-Kelly = Full Kelly / 2
Position size = portfolio_value * Half-Kelly

Why half-Kelly: Full Kelly is optimal only if your probability estimates are perfectly calibrated. They are not. Half-Kelly sacrifices ~25% of growth rate but reduces variance by 50% and reduces probability of ruin dramatically.

Hard Position Size Caps

These caps override Kelly regardless of what the formula says:

Condition	Maximum Position Size
Default	10% of portfolio
Confidence < 0.7	5% of portfolio
News-driven edge	2% of portfolio
First trade with a new strategy	1% of portfolio
Arbitrage (both sides hedged)	20% of portfolio

Minimum Position Size

Do not trade if the position would be less than $10 USDC. Transaction costs and monitoring overhead make tiny positions not worth the effort.

Exit Decision Tree

Profit Exit (Target Hit)

For each edge type, the default target is:

  Arbitrage:      Hold to resolution (guaranteed profit)
  Momentum:       Exit at 80% of estimated move
  Mean Reversion: Exit when price returns to mean
  News-Driven:    Exit within 15 minutes or when market converges

When target is hit, exit the full position. Do not get greedy by moving the target. The original analysis determined the edge -- respect it.

Loss Exit (Stop Loss)

Default stop loss = entry_price - (edge / 2)

Example:
  Entry: 0.45 YES
  Estimated fair value: 0.55
  Edge: 0.10
  Stop loss: 0.45 - 0.05 = 0.40

When stop is hit, exit immediately. No exceptions. The most expensive words in trading are "it will come back."

Time-Based Exit

Edge Type	Maximum Hold Time
Arbitrage	Until resolution
Momentum	48 hours
Mean Reversion	24 hours
News-Driven	15 minutes

If the position has not hit target or stop within the time limit, exit at market. The edge has either been captured or has decayed.

Forced Exit Conditions

Exit ALL positions immediately if:

• Total portfolio drawdown exceeds 20%
• Daily loss exceeds 5%
• Three consecutive stop losses hit
• Market structure changes (API down, unusual activity, flash crash)

Risk Budget

Per-Trade Limits

• Maximum risk per trade: 2% of portfolio (defined as position_size * distance_to_stop / portfolio_value)
• Maximum number of open positions: 5
• Maximum correlated exposure: count correlated positions as ONE position

Daily Limits

• Maximum daily loss: 5% of portfolio
• Maximum number of new trades per day: 10
• When daily loss limit is hit, all new entries are blocked until the next calendar day

Weekly Limits

• Maximum weekly loss: 10% of portfolio
• When weekly loss limit is hit, all new entries are blocked until the next Monday

Drawdown Limits

• At 10% drawdown from peak: reduce all position sizes by 50%
• At 15% drawdown from peak: reduce all position sizes by 75%, no new momentum or news trades
• At 20% drawdown from peak: close all positions, stop trading, full strategy review required

Correlation Rules

Two positions are considered correlated if:

• They reference the same underlying event (e.g., "Will X win?" and "What will X's margin be?")
• They are in the same event group on Polymarket
• One outcome logically implies the other

Correlated positions count as a single position for concentration limits. The combined size of correlated positions must not exceed the single-trade size cap.

When to STOP Trading Entirely

1. Mechanical stop: Any drawdown limit triggered (see above)
2. Strategy failure: Win rate drops below 40% over 20+ trades
3. Model broken: Three consecutive trades where the market moved opposite to your prediction by > 10 percentage points
4. External factors: Major regulatory news, platform issues, API instability
5. Emotional state: Feeling the need to "make it back", trading out of boredom, or ignoring your own rules

When stopped, conduct a full review:

• Were entries following the methodology?
• Were stop losses being respected?
• Was position sizing within limits?
• Has the market regime changed (volatility, liquidity)?

Resume only after identifying the issue and implementing a fix. If no issue is found, reduce position sizes by 50% for the next 20 trades.

Portfolio Review Schedule

Daily (scripts/daily_review.py)

• Calculate P&L for all positions closed today
• Check open positions against current risk limits
• Verify no drawdown limits are being approached
• Review any skipped trades -- was the skip correct?

Weekly

• Win rate by strategy type
• Average edge captured vs predicted
• Largest winner and largest loser -- were rules followed?
• Correlation exposure review
• Adjust parameters if evidence supports it (minimum 50 trades)

Monthly

• Full strategy performance comparison
• Retire strategies with < 50% win rate over 100+ trades
• Evaluate new strategy candidates via paper trading
• Recalibrate Kelly inputs based on actual win rates