What is a Martingale Strategy?

16 July 2021

    What is a Martingale Strategy?

     

    If you are wondering what “martingale strategy” - a term commonly found in trading discussions, means, then you’ve come to the right place. This article will explain what a martingale strategy is, as well as help you understand it and comprehend the consequences of using this method in your trading strategy. It will also provide you with insights on how this method can be used to deceive traders, especially when promoted as an investment opportunity, either in the form of an investable strategy or an algorithmic trading solution.

     

    The martingale method is a strategy based on statistics and probability. It was invented and used widely in the 18th century in France for gambling purposes. The idea behind the martingale method is relatively simple. It states that for every lost stake, you should double the bet on the next one. For example, if you are gambling on a coin flip game and you bet $1 on heads, if tails flip, then you should bet again, but this time the bet should be $2. In case you win the second time, you would have covered the loss of the first flip and make some profit as well. If you lose the bet again, you should double the amount again, betting this time $4. The method should be followed recursively until a winning outcome is reached.

     

    Theoretically, the martingale method is a non-losing strategy, as long as you have an infinitely deep pocket. Nevertheless, nobody has an infinitely deep pocket, therefore a martingale approach to betting will eventually lead to bankruptcy since the cost of betting grows exponentially for each lost bet. If used for long enough, then unavoidably the sequence of lost bets will be such that it will exhaust all the player’s funds.

     

    Martingale in the Markets

     

    Even though the martingale method has been invented for gambling purposes, it has found its way into asset trading. The strategy has been used in three different ways. The first and most common one is by naive traders who do not comprehend the statistical consequences of the method and hope that they can cheat the laws of probabilities forever. Using the martingale method feels good in the beginning, since you see your account growing constantly, but in the long term, such attempts always end in blown trading accounts. It is of 100% certainty that it will happen eventually. 

     

    Another way of using the martingale method is by enhancing an already profitable method. Since successful trading strategies have more than a 50-50 win ratio (or else they would not have been successful), the probabilities are much more favorable for the trader than in a flip coin game or a roulette. In this case, many traders decide to use the martingale method for a limited number of steps, in an attempt to improve their winning ratio even further. A typical example would be a strategy that trades on pullbacks. When a trader is trying to catch a pullback, but places the trade at the wrong level and the price continues to move against the trade, he can decide to double his position at specific levels in loss, in order to obtain a better average price for his position and benefit more from the eventual bounceback.

     

    A third and very popular way of using the martingale method is for generating nice-looking short-term results. Since the martingale method is a constant winning strategy until the final blow up happens, many people take advantage of this behavior for short-term benefits beyond trading. Such benefits include promoting nice-looking results for proprietary trading algorithms, trading signals and strategies. 

     

    Experimenting with the Martingale Method

     

    Fondex cTrader offers you the option to experiment with the martingale method and visualize how it works, using cTrader Automate - the application that allows you to build your own automated trading strategies. cTrader comes with a built-in same of a martingale strategy. To use it just navigate to cTrader Automate > cBots and search for “martingale”

     

     

    Upon searching, you will find a cBot Sample Martingale cBot. Select it and add an instance by clicking on the + button e.g. EURUSD

     

     

    As soon as the instance is added, go to the main panel and select the Backtesting tab

     

     

    Here you can run a backtest of the cBot and visualize how a martingale strategy would have been executed. Check Visual Mode option, select dates and then press the Play button on the right

     

     

    Upon pressing Play, the strategy will start taking trades on your chart. You will notice how the position size doubles every time a previous trade closes in loss. 

     

     

    When the backtesting finishes, you will be able to see the history of trades and the way that the martingale method worked during the execution and how trades doubled until a profit was reached.

     

     

    Another important aspect you should pay attention to is the equity chart

     

     

    Observe the linear increase in the account’s balance associated with steep drawdowns. This is a typical signature of a martingale-based trading approach. If you see this pattern anywhere - it is a clear indication that some form of the martingale method has been used.

     

    Is Martingale a Good Idea?

     

    To keep it short, using a naive martingale method for a long time is a guaranteed recipe for destruction. Any martingale algorithm will eventually reach that maximum number of bearable losses. If you want to experiment with martingale, you should only do so using a strategy that has an edge over the market and only in controlled risk conditions e.g. a predefined number of steps that will not blow your account. Besides that, it is always a good idea to be familiar with the martingale method and its inner workings, so that you can spot when and if it is being used to deceive you.


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