Understanding the Martingale Forex Strategy

17 Oct 2019

Understanding the Martingale Forex Strategy

If you flip a coin and choose heads over and over again, there is a strong probability that you will eventually win at some point in time. The Martingale strategy is based on similar fundamentals. Introduced in the 18^th century, the Martingale Strategy of investing is based on increasing position sizes, while lowering the size of the portfolio. Statistically, a trader cannot lose all the time. So, according to the strategy, if you keep on increasing your investment allocations (despite losses), there are chances that a single successful trade will eventually reverse all your losses. If it sounds too much like gambling to you, you are quite right. The system was originally developed as a betting style, based on the strategy of “doubling down,” by mathematician Paul Pierre Levy. It was commonly practised in the Las Vegas casinos, which is why casinos today have betting minimums and maximums and why there are two green markers on the roulette wheel, in addition to the odd and even bets. It is a highly risky strategy and is not too favoured by traders today. However, knowledge is key and therefore it’s useful to learn about the Martingale strategy.

Relevance in the Forex Market

Position sizing is a tricky but vital aspect of trading. The Martingale strategy deals with this aspect. It is a negative progression system, which includes increasing your position size after a loss. More specifically, doubling the position size. Traders then try to trade an outcome, which has 50% probability of occurring. The strategy seems suited to someone with an infinite supply. With a large number of buy orders, a trader will eventually score a win at some time and in case they have doubled their position size after each loss, when they do win, they might not just recover all their losses but also get back the original investment.

Steps in the Trading System

Every trade has two potential outcomes, profit and loss, and both have equal probabilities of playing out. So, let’s name the outcomes A and B. Now, imagine you enter a trade for $10, hoping to get the A outcome but instead you end up with B. Note, that the risk-reward ratio is 1:1. Next, you trade $20, again hoping for outcome A, but get outcome B. Now, you have lost $30 in total. You continue doubling down till your desired outcome occurs. Eventually, the size of the winning trade will exceed the losses. If you had a huge amount of capital, the following steps could have yielded the results.

Use the currency pair and timeframe
Determine the basic position size
Place a buy or sell order, with fixed stop-loss and take-profit levels
When the stop-loss or take-profit get triggered, you either win or lose
If you win, go back to step 3. If you lose, double your position and go back to step 3.
With unlimited trading capital, you might just score a huge win eventually.

You can see why such a strategy would be appealing. Firstly, under specific conditions, it gives a predictable outcome, in terms of profits. With the right application, it could even be possible to achieve an incremental profit rise. Secondly, the strategy doesn’t need you to predict market trends or price direction. This could be useful during highly volatile conditions. Also, currencies tend to trade sideways for a long period of time, which means that the same levels can be exploited several times. This strategy can act as a yield enhancer in such cases. This is when trade sizes are smaller compared to the capital reserves, which means low leverage utilisation. In this way, traders could bear the higher trade multiples in times of drawdown.

Reasons Why the Strategy Fails

Trading is not really about wins and losses, as depicted in the 50:50 bet proposition. The relative sizes of wins and losses vary. For instance, just one pip gain can also be counted as a profit, but then you can go on to lose by 500 pips. All this depends on where stop-losses and take-profit levels are fixed, as well as market volatility. It also depends on fundamental factors and your ability to predict the market trend. The odds of each trade are influenced by several factors. So, this binary version of wins and losses is not an accurate representation of trading. In the financial markets, the chances of a win are not the same as that for losses. The market might need to move twice as far to trigger the take-profit, as compared to triggering stop-losses. Then there is the ability to use leverage while trading forex. This means that even small movements against your position could lead to huge losses. In such cases, 3 or 4 consecutive losses could completely wipe out your trading account. It’s clearly not tailored for long-term traders. The longer you trade, the higher are the chances of losing money. When losses continue for a long streak, traders might not be able to sufficiently increase their position sizes to retrieve their losses, even if they have a huge capital base. Many think that Martingale is suitable for carry-trade opportunities. The idea of positive carry trades is based on the accumulation of positive roll-over credits through large open trade volumes. However, carry trade currencies are usually strongly trending, which means that traders are likely to see steep corrections in price movements due to reverse carry positioning. Unexpected changes in interest rate cycles can quickly lead to funds flowing out of high-yielding currencies. Martingale doesn’t really work in such trending markets, as studies have proven over time. Overall, it looks like a lot of dependence on guesswork and luck. It doesn’t increase the odds of winning, but only delays losses, which is sheer luck. The strategy is based on a popular myth that the markets behave randomly, which is not the case. If traders decide to follow the strategy, they need to know that while profit expectations increase linearly, risk exposure increases exponentially in such trades.

Knowledge