Martingale Strategy
This strategy intends to recover all previous losses while obtaining a profit on the first win.
What is the Martingale Strategy?
Originating from 18th century France, the martingale strategy is a class of betting strategies where the trader doubles the size of trades after every loss. This strategy intends to recover all previous losses while obtaining a profit on the first win.
In a nutshell, it is a cost-averaging strategy that doubles exposure on losing trades. This approach is made by immediately doubling the size of a bet after experiencing a loss.
How does using a trading strategy with an almost 100% probability success rate sound?
Statistically, one won't lose all the time, especially concerning gambling at the roulette table. This strategy aims to anticipate future price rises, and traders should increase the bet amount to capitalize, regardless of a profit or loss.
Concerning trading, investors decide how much to bet on the price of trade to go up or down. If they lose this investment, they double the amount they first bet and try again.
Commonly referred to as a "double or nothing" approach, it is based on basic probability theory. However, in application to trading and investing, it is used by experienced traders, mainly surrounding foreign exchange (Forex) trading.
Understanding the Martingale Strategy
The most superficial case study of martingale is a gambling game where a coin is tossed, with heads resulting in a win and tails in a loss. The probability of either side of the coin is 50/50.
The gambler is almost sure to flip heads over time; therefore, with infinite wealth and time, this betting strategy will make profits.
This is unrealistic in the real world, where the probability of success, time, and wealth are limited resources.
Commonly used within casinos and gambling halls, this betting strategy assumes that the price of a bet will often reset, giving the recipient a 100% profitable strategy. This is, of course, if you hold great riches.
This assumption is based on mean reversion theory, where asset prices eventually converge to their long-term average price. Without deep pockets or a bag full of gold, missed trades can cripple or even bankrupt traders.
Martingale strategy origin
This strategy was introduced into probability theory by Paul Lévy in 1934, who studied the inability of successful betting strategies to succeed in games of chance.
This approach to gambling and trading is believed to be named after John H. Martindale, a casino owner in 18th-century London who was known for encouraging players to double their bets after they lost. However, the name was coined by French mathematician Jean Ville in 1939.
The entry for martingale in the Academic French dictionary (Académie Française) was introduced in the fourth edition in 1762:
"To play the martingale is always to bet all that was lost."
Going further back, in 1750, the abbé Prévost dictionary defines the strategy in which the gambler doubles his stake at each loss "to quit with a sure profit, provided that he wins once."
Within mathematical statistics, a martingale is a sequence of random variables X1, X2 … Xn where the conditional expectation of Xn+1 = Xn.
E(|Xn| > ∞
E(Xn+1 | X1, ..., Xn) = Xn
In application to quantitative finance, a martingale is a pricing approach to derivative contracts. However, this has nothing in common with the martingale strategy.
Example of the Martingale Strategy
This is the primary example of the martingale betting strategy.
Imagine a coin-betting game with a 50:50 chance of either winning on heads or losing on tails, assuming we start with $10 and a $1 bet.
| Wager | Prediction | Outcome | Profit/Loss | Account Balance |
|---|---|---|---|---|
| $1 | Heads | Tails | -$1 | $9 |
| $2 | Heads | Tails | -$2 | $7 |
| $4 | Heads | Heads | $4 | $11 |
The first flip of the coin results in tails, losing $1. For the next flip, we wager $2 to retrieve the previous loss while still making a profit of $1. However, the coin lands on tails, and the total account balance is now down to $7.
Maintaining this betting strategy, we again double-down the wager to $4. The third time's a charm, and we receive $4 in profits, totaling our account balance to $11.
Even after losing the bet the first two times, we recoup all losses and even gain $1 in total profit by doubling down on our investment.
The Martingale System In Forex Markets
Stock markets do not hold an equal probability of winning or losing compared to our previous gambling game. Therefore this basic betting strategy must be altered for use within a market.
Therefore, the 'doubling-down' aspect of the approach is modified without a strict binary outcome. Instead, trades close with a sure profit or loss, regardless of whether you have recouped your losses.
Let's use an example of a forex ticker GBP/USD. This ticker tells us how many US dollars are needed to buy a pound.
| GBP/USD | Order lots | Break-even price | Loss | Break-even (pips) |
|---|---|---|---|---|
| 1.100 | 1 | 1.100 | $0 | 0 |
| 1.098 | 2 | 1.099 | -$2 | -20 |
| 1.096 | 4 | 1.098 | -$6 | -40 |
| 1.094 | 8 | 1.097 | -$14 | -60 |
| 1.097 | 16 | 1.097 | $2 | 0 |
As shown above, as the GBP/USD drops from 1.100 to 1.098, we need the ticker to raise to 1.099 to break even. As the price increases, we double each time until we have lost $14 at 1.094.
At this price, we need it to rise to 1.097, where we can sell the stock and recoup our losses. The more lots we added, the lower the break-even price became until the price reached that point, at which we were able to leave with a profit of $2.
The enticement towards using this betting strategy within currency markets is due to the safety of a country's currency. Very rarely does a currency ever drop to zero, in stark contrast to the stock market, where businesses can face bankruptcy.
Forex trade's profit/loss can be categorized as a variable outcome. Price levels are defined as where profits are taken or to cut losses. As a result, potential profit or loss amounts can be seen as equal.
Traders have an advantage over gamblers in controlling their running trades. Explaining and managing that advantage using loss-cutting techniques can keep losses small while returning profits.
With Forex, deep-pocketed traders can gain interest in their trades, therefore neutralizing their losses. Everyday use of this strategy involves borrowing with a low-interest rate currency to purchase a higher-interest currency.
Using Martingale Strategy outside trading
Outside of trading, this strategy is widespread for traditional casino games.
It is most extensively used in roulette due to the near 50/50 odds. In the roulette game, you can bet on either red or black, odd or even or the 1-18 or 19-36 number groups. However, it is not precisely 50/50 odds due to the green zero.
The application of this system in roulette revolves around our simple example. The only guarantee of profit is to walk away when given the first profitable win, not allowing a continuation of winning streaks.
Known for breaking the Monte Carlo bank numerous times, renowned gambler Charles De Ville Wells attributes his success to the martingale approach. Over an 11-hour playing time in one instance, he won over 1 million francs on the roulette table, approximately $13 million in today's time.
Despite the success, Wells lost all his money and died pennilessly.
Advantages of the Martingale Strategy
The most significant advantage is its ability to generate a win within the short term. Martingale can succeed if players do not enter a streak of long-lasting consecutive losses. Let's take a look at some of the benefits below:
- Can generate wins and cover losses in a short period.
- They are mathematically proven to work, given the needed resources.
- Easy to understand and suitable for both experts and beginners.
- Under the correct application, it is possible to get an incremental profit rise.
- Market trend prediction is not required under the presumption of mean reversion theory.
Disadvantages of the Martingale Strategy
Wealth and time are the two essential components of use with this strategy and are the most significant drawbacks. Apart from that, the drawbacks include:
- Size limits may be placed on trades, refusing the trader the ability to double their bet an infinite number of times.
- The trader may run out of funds and be unable to recoup the losses incurred.
- As more losses are sustained, higher amounts of cash are needed, while the only return profit is the original bet size.
- Stocks may stop trading at any given point.
- Transactional costs incurred are not included in this strategy.
- Poor market conditions, such as bear markets or recessions, increase traders' ability to take on significant losses.
Summary
To encapsulate Martingale's theory: it is a system that works well in addition to a trader's set of strategies, but as a sole basis for trading, it will eventually fail.
Without the option of infinite resources, even Jeff Bezos will lose.
On paper, the strategy offers an inevitable win, regardless of the losses incurred beforehand. However, while this may be so, traders may be too deep in a loss to recover financially.
The Martingale system has a chance to bring small winnings to you in the short term, but due to the steep progression of its nature, this strategy is precarious for a long time.
This approach averages a much smaller profit pool and can generate more significant amounts of risk than rewards earned. Many speculate that due to this steep risk-to-reward value, the final profit only equaling the starting investment bet does not justify the potential losses.
Therefore, traders must continuously plan and adapt to and around this strategy.
Before applying this strategy and doubling down, investors should consider whether their due diligence and research are solid or consider the possibility of a mistake and attempt to limit the losses made.
Even experienced and sophisticated traders with large portfolios should try this strategy with caution. First, you should be comfortable with losing your account in a single trade. If not, steer far clear of this system.
Martingale Strategy FAQs
In a non-practical situation, this approach will always retain. However, the unlimited resources needed for this trading system to succeed cannot be achieved in the real world.
Achieving 100% success on every bet made is not possible. Nevertheless, traders can increase their success rate considerably through this approach and have done so since the 18th century.
This strategy has a high risk-to-reward value, where traders must be willing to lose all their account balances to make a small profit on a single trade. Risk will keep increasing for each trade as you can not predict the number of successive losses.
The Paroli strategy, commonly known as the anti-martingale system, increases the winning bets while minimizing lost bets.
The strategy involves doubling your betting size after winning, capitalizing on a winning streak.
The Paroli has two advantages:
- The simplicity of doubling the winning bet.
- There is no risk of losing excessive amounts of money.
This system is often considered a better alternative for traders as it is less risky to increase the bet size while on a winning streak than a losing streak.
The reasons are:
- Too small of an account can cause all of a trader's account equity to be lost without the possibility to keep doubling down.
- Not defining a maximum loss can cause funds to dry out unexpectedly due to the increased size of the bets needed.
- Creates loss aversion, where you seek to avoid losses rather than to seek profits.
- The system will never work out long-term due to limited resources.
- Equal probabilities cannot be achieved in trading, therefore never meeting the ideal settings needed for this approach.
This approach may not be safe in trading due to external factors, regardless of whether there is a statistically computable outcome or not. On paper, the martingale offers an inevitable win, regardless of the losses incurred beforehand.
With limited resources, however, most people steer clear of this method, commonly due to boundaries set on the limited account balance.
This approach is relatively risky because the probability of losing money is infinite. Traders can never be sure that the trade will reverse in their favor, resulting in a loss of a trader’s account balance.
Researched and Authored by Matthew Coe
Reviewed and edited by Parul Gupta | LinkedIn
Free Resources
To continue learning and advancing your career, check out these additional helpful WSO resources:
or Want to Sign up with your social account?