Would you be interested in a trading strategy that is virtually 100% profitable? Amazingly, such an approach exists and dates back to the 18th century. The martingale strategy is based on probability theory. If your pockets are deep enough, it has a near 100% success rate.
The martingale strategy was most commonly practiced in the gambling halls of Las Vegas casinos. It is the main reason why casinos now have betting minimums and maximums. The problem with this strategy is that you need a significant supply of money to achieve 100% profitability. In some cases, your pockets must be infinitely deep.
A martingale strategy relies on the theory of mean reversion. Without a plentiful supply of money to obtain positive results, you need to endure missed trades that can bankrupt an entire account. It's also important to note that the amount risked on the trade is far higher than the potential gain. Despite these drawbacks, there are ways to improve the martingale strategy that can boost your chances of succeeding.
- The system's mechanics involve an initial bet that is doubled each time the bet becomes a loser.
- All you need is one winner to get back all of your previous losses.
- Unfortunately, a long enough losing streak causes you to lose everything.
- The martingale strategy works much better in forex trading than gambling because it lowers your average entry price.
What Is the Martingale Strategy?
The martingale was introduced by the French mathematician Paul Pierre Levy and became popular in the 18th century. The martingale was originally a type of betting style based on the premise of "doubling down." The American mathematician Joseph Leo Doob continued work on the martingale strategy. However, he sought to disprove the possibility of a 100% profitable betting strategy.
The system's mechanics involve an initial bet that is doubled each time the bet becomes a loser. Given enough time, one winning trade will make up all of the previous losses. The 0 and 00 on the roulette wheel were introduced to break the martingale's mechanics by giving the game more possible outcomes. That made the long-run expected profit from using a martingale strategy in roulette negative, and thus discouraged players from using it.
To understand the basics behind the martingale strategy, let's look at an example. Suppose we had a coin and engaged in a betting game of either heads or tails with a starting wager of $1. There is an equal probability that the coin will land on heads or tails. Each flip is an independent random variable, which means that the previous flip does not impact the next flip. If you doubled your bet every time you lost, you would eventually win and regain all of your losses, plus $1. The strategy is based on the premise that only one trade is needed to turn your account around.
Examples of the Martingale Strategy in Action
|Your Bet||Wager||Flip Results||Profit/Loss||Account Equity|
|Heads||$ 1||Heads||$ 1||$11|
|Heads||$ 1||Tails||$ (1)||$10|
|Heads||$ 2||Tails||$ (2)||$8|
|Heads||$ 4||Heads||$ 4||$12|
Assume that you have $10 to wager, starting with the first wager of $1. You bet on heads, the coin flips that way, and you win $1, bringing your equity up to $11. Each time you are successful, you continue to bet the same $1 until you lose. The next flip is a loser, and you bring your account equity back to $10. On the following bet, you wager $2 to recoup your previous loss and bring your net profit from $0 to $2. Unfortunately, it lands on tails again. You lose another $2, bringing your total equity down to $8. Pursuing the martingale strategy, you double your wager to $4 on the next bet. Thankfully, you hit a winner and gain $4. That brings your total equity up to $12. As you can see, all you needed was one winner to get back all of your previous losses.
However, let's consider what happens when you hit a losing streak:
|Your Bet||Wager||Flip Results||Profit/Loss||Account Equity|
You once again have $10 to wager, with a starting bet of $1. In this case, you immediately lose on the first bet and bring your balance down to $9. You double your bet on the next wager, fail again and end up with $7. On the third bet, your wager goes up to $4. Your losing streak continues, bringing you down to $3. You do not have enough money to double down, and the best you can do is bet it all. You then go down to zero when you lose, so no combination of strategy and good luck can save you.
Strict application of the martingale strategy produces a 100% success rate until it ends with the complete loss of all capital.
Application to Trading
You may think that the long string of losses, such as in the above example, would represent unusually bad luck. But when you trade currencies, they tend to trend, and trends can last a long time. The trend is your friend until it ends. The key with a martingale strategy, when applied to the trade, is that by "doubling down" you lower your average entry price. In the example below, at two lots, you need the EUR/USD to rally from 1.263 to 1.264 to break even. As the price moves lower and you add four lots, you only need it to rally to 1.2625 instead of 1.264 to break even. The more lots you add, the lower your average entry price. You may lose 100 pips on the first lot of the EUR/USD if the price hits 1.255. On the other hand, you only need the currency pair to rally to 1.2569 to break even.
This example also provides a clear example of why significant amounts of capital are needed. If you only have $5,000 to trade, you would be bankrupt before you could see the EUR/USD reach 1.255. The currency should eventually turn, but you may not have enough money to stay in the market long enough to achieve a successful end. That is the downside to the martingale strategy.
|EUR/USD||Lots||Average or Break-Even Price||Accumulated Loss||Break-Even Move|
Why Martingale Works Better With Forex
One of the reasons the martingale strategy is so popular in the currency market is that currencies, unlike stocks, rarely drop to zero. Although companies can easily go bankrupt, most countries only do so by choice. There will be times when a currency falls in value. However, even in cases of a sharp decline, the currency's value rarely reaches zero.
The FX market also offers another advantage that makes it more attractive for traders who have the capital to follow the martingale strategy. The ability to earn interest allows traders to offset a portion of their losses with interest income. That means an astute martingale trader may want to use the strategy on currency pairs in the direction of positive carry. In other words, they would borrow using a low interest rate currency and buy a currency with a higher interest rate.
The Bottom Line
A great deal of caution is needed for those who attempt to practice the martingale strategy, as attractive as it may sound to some traders. The main problem with this strategy is that seemingly surefire trades may blow up your account before you can profit or even recoup your losses. In the end, traders must question whether they are willing to lose most of their account equity on a single trade. Given that they must do this to average much smaller profits, many feel that the martingale trading strategy offers more risk than reward.
Michael Mitzenmacher, Eli Upfal. "Probability and Computing: Randomized Algorithms and Probabilistic Analysis," Pages 295-308. Cambridge University Press, 2005. Accessed May 25, 2020.
Electronic Journal for History of Probability and Statistics. "How Paul Levy Saw Jean Ville and Martingales," Page 2. Accessed May 25, 2020.
University of Illinois. "Joseph Doob." Accessed May 25, 2020.
Massachusetts Institute of Technology. "Martingales, Risk Neutral Probability, and Black-Scholes Option Pricing," Page 5. Accessed May 25, 2020.