Much has been written about the infamous martingale strategy, especially by people trying to impress novice traders. At first glance, it looks like an intuitive strategy promising potentially high returns. However, is it really all it’s hyped to be, or is it just another gimmick strategy that can’t stand on its own legs?
What Is the Martingale Strategy?
In simple terms, the martingale is a betting strategy in which you double your bet after every loss. You know how people say “double or nothing” when betting and then go on to win big? This is pretty much what the martingale strategy is all about.
The idea here is the ability to sustain losses knowing that the first win can overturn them all and even give you a nice profit. That’s the theory behind it, at least.
Let’s look at a coin flip, for instance. There’s a 50/50 chance that it will land on heads or tails. If you bet $10 on tails, but then it lands on heads, you just lost $10. So you go again, this time doubling the stake to $20. If you lose again, you double up to $40.
When you eventually win, the money you made from that one win should be enough to recover all the previous losses incurred and even make a profit. After your first win, you can leave the table with your profit or gamble again, starting with a minimal amount.
|Stake||Flip Outcome||Profit/Loss||Running Balance|
The first four coin flips saw you lose a total of $150 because you were doubling down the stake after each loss. However, on the fifth flip, you got a win and earned $160, which is enough to cover your $150 loss and even get a $10 profit.
If you reset the strategy and bet $10 again on the next flip and win, you make another $10 profit. If you lost, then you’d simply double it again until you get your win.
Sounds simple enough, right?
In theory, you could keep doubling down even for the next 25 flips and lose the first 24 flips (the probability of that is low). But on the winning flip, you make more than enough money to cover your losses and net a profit.
HISTORY AND ORIGINS IN GAMBLING
Because it is based on betting and probability, it’s not surprising that the martingale strategy has its roots in gambling. There are two primary schools of thought on how it came to be.
Many believe it originated in 17th or 18th century France, like most modern gambling traditions. At the time, gambling was the order of the day; the upper class gambled with more money than sense while the lower class gambled what they had to afford a life.
Because it was becoming so rampant, various scholars started looking at the science behind the probability of various games. Among these scholars, French mathematician Paul Pierre Levy is credited with making the martingale strategy a popular method for profitable betting.
The second school of thought believes that the strategy was named after John Henry Martindale, a casino owner in London. John was said to encourage gamblers in his casino to wager by doubling down their stakes since the mathematics proved that they were guaranteed to earn their money back with a little profit on the side.
As if to prove his point and make the martingale even more popular, a famous gambler known as Charles De Ville Wells would go on to use the strategy to turn 4,000 francs into over 1,000,000 francs in Monte Carlo. He was so successful that he inspired the 1891 song “The man who broke the bank at Monte Carlo.”
The martingale strategy became widely used in Roulette since it’s all about betting on either black or red (50/50 chance). That’s one of the reasons the 0 and 00 were added to the roulette wheel. It introduced more possible outcomes than just black and red.
CRITICISM OF THE MARTINGALE STRATEGY
It’s pretty obvious what the main criticism of the martingale strategy would be — you need bottomless pockets to keep doubling down your bets with every loss. What if you hit an exceptionally long losing streak and you run out of cash before your first win?
Remember that the size of the bet keeps growing to enormous proportions after the initial wagers. When that losing streak continues for too long, you might have to take your compound losses and make a hasty exit before you ever get the chance to recoup your losses.
If you really think about it, the risk-reward ratio is not that favorable either. Whether gambling at the casino or trading securities, nobody wants to lose. So while, in theory, the martingale strategy seems foolproof, the reality is that accelerating your losses in hopes of turning a meager profit equal to your initial bet size is not just impractical but downright hazardous.
Lastly, the strategy does not take into account other costs that may be associated with placing the bet. These additional costs can add up along with your losses and quickly turn into a major risk you cannot afford to maintain.
Can You Use the Martingale Strategy for Trading?
In theory, yes. After all, in trading, you’re basically ‘betting’ on which direction the price of the security will move — up or down. The more appropriate question is, “should you use the martingale strategy to trade?”
Before answering that question, let’s take a look at how this strategy could even work in trading.
There are two possible outcomes to every trade — profit and loss. All else being equal, both have equal probabilities of playing out. For example’s sake, let’s name these outcomes X and Z. Now, let’s say you enter a trade for $50 in the hopes of obtaining outcome X. Instead, you end up with outcome Z. The risk-reward ratio here is 1:1.
You then enter the next trade with $100, again hoping for outcome X, but it still comes out as outcome Z. You’ve now lost $150 in your first two trades. Your next trade will be at $200, and if you still get outcome Z, you place another trade at $400, and so on.
Eventually, the market should turn in your favor, and your returns from getting outcome X will exceed all your previous losses while also giving you a profit equal to your initial trade amount (in this case, $50).
STEP BY STEP BREAKDOWN
If you had access to huge trading capital, here are the steps you would have taken to achieve that result:
- Pick the security to trade and timeframe
- Determine the basic position size
- Place your buy or sell order
- Set your fixed stop-loss and take-profit levels
- You either win or lose when the stop-loss or take-profit get triggered
If you win, go back to step 3 and open a new trade. If you lost, double your position and start again at step 3. With a huge amount of capital at your disposal, you should eventually score a win.
You can immediately see the alleged appeal of the strategy. For one, it provides you with a predictable hypothetical outcome under specific conditions. In theory, you could even gain an incremental increase in profit if you do it right.
Secondly, with the martingale strategy, you don’t have to try and predict price direction or market trends since you’re guaranteed a profit from every win. Could that perhaps make it useful in highly volatile markets?
USING THE MARTINGALE STRATEGY IN THE STOCK MARKET
In principle, the martingale strategy is used for situations where there is a 50/50 probability of a win or loss. As you may well know, the stock market or any financial market for that matter can never be neatly reduced to a few easy probability numbers. It’s never as simple as a coin flip or betting on a roulette table.
That’s why if you even want to consider using the martingale strategy in the stock market, it must first be modified a bit. Let’s look at an example.
Suppose you made a purchase of $1,000 worth of shares at $10 per share. Over the next few days, the stock price drops 50%, so you buy more shares, this time with $2,000 at $5 per share. Assuming the stock price falls 50% from that point, you make another purchase of $4000 at $2.50.
$1000 + $2000 + $4000 = $7000 total amount invested
100 + 400 + 1600 = 2100 total shares owned
The average cost per share is now at 7000/2100 = $3.33
At this point, you can successfully exit the trade and make a profit once the price reaches $3.81 — 2100 x $3.81 = $8,001
$8,001 – $7000 = $1001 (your original invested amount + $1,001 profit)
Any price above $3.33 means a small profit on your trade.
Of course, just to reiterate one more time, this is all hypothetical. These situations hardly ever play out exactly the way we imagine them. Also, there’s no guarantee that the stock price will immediately go back above the average price after initiating the third position.
If the stock price keeps falling and you keep doubling your investment, it could reach the point where you’ll have nothing left to put in. Therefore, be forced to exit the trade with a pile of compounded losses.
THE MARTINGALE STRATEGY AND FOREX
Like the stock market, there usually isn’t a rigid binary outcome in forex trading. Yes, there are still two main possible outcomes, but the trade will often close with a variable amount of profit or loss.
In any case, the principle behind the martingale strategy remains the same. Here, you simply have to define your profit target and stop-loss threshold based on a certain number of pips. Also, what you’re doubling down in this instance are your lot sizes.
Perhaps the martingale strategy could work marginally better in forex trading because doubling down on your lot sizes effectively lowers your average entry price. Also, with currency trading, trends can last a long time, and until it ends, the trend is your friend.
We assume that your profit target and stop-loss levels are set at 20 pips. So for the first trade, the trader purchases one lot at 1.2500. The currency pair loses 20 pips down to 1.2480. This triggers the stop-loss. But rather than exit the position, the trader purchases two more lots at 1.2480 per lot. The average entry is now 1.2490 — 1.2500 + 12480/2.
At this point, even though the unrealized loss has not changed, the trader now only needs the rate to go up by 10 pips to break even. By doubling down on the lot size, the trader reduces the relative amount they need to recover the unrealized losses.
By the fifth trade, the profit gained covers all the losses sustained from the previous four trades. An automated forex trading system can close out these trades once the profit is realized or hold the currency pair in anticipation of greater profits.
Another reason for the popularity of the martingale strategy in forex is that, unlike stocks, there is a much lower chance of the currency value dropping all the way to zero. Yes, there might be some wild swings, but rarely will the value reach zero.
As such, traders can keep doubling down, slightly safer in the assumption that the market will eventually turn in their favor, giving them more chances to recover all their losses from just one win.
DRAWBACKS AND RISKS
Despite posing as a mathematically sound trading strategy, the reality is that the potential risks of the martingale far outweigh the potential rewards. Here’s why:
- You’ll need an infinite amount of capital, which, realistically, isn’t something the average trader (or possibly not even the best trader in the world) has access to. You may run out of funds before the market turns in your favor. You’ll then be forced to exit the trade with disastrous losses.
- The martingale strategy relies on a binary version of equal probabilities. In stock or forex trading, however, the odds of each trade are influenced by countless factors. As such, they never quite meet the ideal settings for martingale trading.
- There’s also a potentially huge problem when trading with leverage. Even small price movements against your position can result in heavy losses. In such instances, your entire trading account could be wiped out after three or four consecutive losses.
- Spending increasing amounts of your trading capital to achieve a profit equal to your initial position doesn’t make much sense. To realize a reasonable profit, your initial position size would have to be huge. However, that would mean the amounts by which you “double down” will be immense as well.
- The strategy doesn’t account for the transaction costs that come with every trade made. This means you’re losing more every time you double down.
- Your trading platform may place limits on how many times you can place a trade, as well as the trade size. This means the trader doesn’t have an unlimited number of chances to double their position. If the market doesn’t turn in their favor within the limited chances set by the platform, then they’ve sustained heavy losses with no chance of recovery, let alone profit.
As the name implies, the anti-martingale strategy is where you double the position size when you profit from a trade. Traders do this hoping that the price of the security or currency value will continue to go up.
The hypothetical ideal scenario for this strategy would be an established bull market. It could theoretically also work well in momentum trading since, with more buyers in the market, the price of the security keeps going higher.
The primary advantage promised by the anti-martingale trading strategy is that you might earn more profit by doubling up the amount you’re investing per trade. Additionally, the risk is minimized during unfavorable conditions since the trade volume doesn’t increase when the market price goes down.
That being said, if there is an extended losing streak in the market, then you’re not making any profit at all because the profit and loss positions will alternate. You’ll need to determine your entry and exit points accurately so that the losses don’t cover the profits made.
Your success as a trader mainly comes down to the effectiveness of your trading strategy. There are dozens upon dozens of trading strategies out there. It’s become more important than ever to understand their respective pros and cons, so you know if it’s worth implementing.
In the case of the martingale strategy, the devastating drawbacks overshadow any potential benefits. Overall, succeeding with this strategy depends mainly on luck and access to infinite capital.
More importantly, it doesn’t increase the odds of you actually winning the trade. Instead, it delays your losses in the hopes that a win comes in before your money dries up. Essentially, your profit expectations are only increasing linearly, whereas your risk exposure is increasing exponentially.
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