Just search Google for any Martingale related article and you will not only learn about this “betting” system, you will probably shut off your computer, dismissing Martingale as massively dangerous with 100% accuracy – in wiping out your account. It is easy to condemn Martingale with a few robot backtests, but can the Martingale trading concept be managed such that it fits into our trading portfolios? In this article, we explore the math behind Martingale, and also forward test a basket of expert advisors we are developing.
Nothing is without risk
First and foremost, nothing is without risk, not even the US treasury bills. By assuming risk in markets, we should enjoy a proportionate return, based on market efficiencies. We cannot judge Martingale systems with a flawless lens because every trading system or logic has its weaknesses, and every single trading system can be destroyed by market extremes. We have seen how hedge funds such as Long-Term Capital Management collapsed in the late 1990s, leaving some of their best minds helpless.
Safer than your current trading system
Most of us are no better. Easily 80% of retail traders have their committed trading capital wiped out, even without Martingale trade management. Based on this statistic, your current trading style is likely to be as risky, if not riskier compared to well-managed Martingale strategies. This statement is of course very general because traders could get their accounts wiped out due to numerous reasons, such as failure to control emotions. What we have to understand is that there are risks in every trading system, and the only variable we can manage is to stack the odds of winning in our favour, knowing that there is always a possibility for loss.
Martingale in a nutshell
Martingale strategies increase position sizes as trades go against you, while anti-martingale strategies increase position size as trades work in your favour. In a loose sense, Martingale strategies seem to contradict the Golden Rule of trading, of letting your profits run and cutting your losses short, since a trader takes on a bigger position of the same strategy when faced with a loss. That said, Martingale can be compared to the very common investing practice of “averaging down”, which is buying more as the position goes against you, which brings the breakeven point closer to you.
Martingale as a standalone theory is a math logic, not a trading logic. While trading indicators and entry/exit strategies determine trading logic, Martingale is usually employed as a position sizing and money management concept.
The original 18th century Martingale was based on 2 key assumptions: doubling position size on each trade loss, and playing a game with 50% win rate – example being a coin flip. When we apply this to forex trading with 100:1 leverage, the probabilities stack up as such:
The table above shows 14 consecutive losses, with the 14th trade requiring a margin of $81,920. The probability of this occurring is 1 in 10,000, or 0.01%. This seems pretty risky, especially since Martingale trading works on the assumption that you have sufficient trading capital to recoup from consecutive losing trades.
The above example is a traditional Martingale, and many modern MT4 expert advisors have been modified since. Let us see how the probabilities stack up for another trading system with 65% win rate, meaning this trading system has better win rate than a coin flip. In addition, instead of “doubling down” the position, each losing trade is followed by a trade size multiple of just 1.6x (also known as “Lot Exponent” or “Lot Multiplier”):
Now 2 interesting outcomes are observed. Firstly, the margin required on the 14th trade is now only $4,504. Secondly, the probability of the 14th Martingale trade happening is now 1 in a million. In other words, it is almost certain that there will be a profitable trade before you reach the 14th trade. This should allow you to recover a significant amount of prior losses, just not as quickly as the original Martingale because the Martingale multiple in this example is only 1.6x, instead of 2x.
Martingale forward tested
We forward tested a basket of Martingale strategies under development, and below are the results after 1,368 trades. This trading system has a win ratio of above 65%, and a Martingale multiple of under 2x, similar to the calculation in the table above. As you can see, the maximum consecutive loss was 10 times. The probability of this occurring is 1 in 35,000. This string of losses contributed to a 10.38% drawdown near trade #745, and gradually recovered. Again, the recovery was not immediate like traditional Martingale systems because the Martingale multiple was under 2x.
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If you like the Martingale Trading system, we describe in a follow up article 7 tips and strategies when applying Martingale Forex Trading.
Written By: Streetpips.com
Profile bio: Streetpips.com scans books and websites for trading strategy ideas. We then select those which are programmable, code them, and share these with our members.