Forex Trading Using the Martingale System
Most forex investors (traders) will probably reply with a resounding “Yes!” if there were asked whether they would be interested in a trading strategy that is practically 100 percent profitable. Amazingly, such a trading strategy exists and it dates back to the 18th century. This strategy is mainly based on probability theory and if your pockets are deep enough, the success rate is almost 100 percent.
Known in the financial trading world as the martingale, this strategy was most commonly executed in the gambling halls of Las Vegas casinos. It is the major reason why casinos now have minimum and maximum bets, and why the roulette wheel now has two green markers (0 and 00) in addition to the popular odd or even bets. The challenge with this strategy is that to achieve 100% profitability, you need to have deep pockets; in some cases, the pocket must be infinitely deep.
No one has infinite wealth, not even the government, but with a theory that heavily relies on mean reversion, one missed trade can completely bankrupt an account. Also, the total amount risked on the trade would in most cases be far greater than the potential return. Despite these obvious drawbacks, there are ways to significantly improve the martingale system. In this piece, we will explore the means and methods you can employ to considerably improve your odds of succeeding at this very high-risk and difficult strategy.
What is the Martingale Strategy?
Made popular in the 18th century, the martingale trading strategy was introduced by the renowned French mathematician Paul Pierre Levy. The martingale system was originally a type of betting style based mainly on the premise of “doubling down.” A lot of the work done on the martingale strategy was done by an American mathematician named Joseph Leo Doob, who sought to disprove the possibility of a 100 percent profitable betting strategy.
The system’s mechanics generally involve an initial bet (trade in this situation); however, each time the bet (trade) becomes a loser, the wager is doubled such that, given enough time, one winning trade (bet) will make up all of the previous losses. The 0 and 00 on the roulette wheel were mainly introduced to break the martingale’s mechanics by giving the game more than two possible outcomes other than the red versus black or odd vs even outcomes. This eventually made the long-run profit expectancy of employing the martingale system in roulette games negative, and thus destroyed any incentive for utilizing it.
To deeply understand the mechanics behind the martingale system, let us look at a simple instance. Suppose we had a coin and engaged in a betting game of either tails or head with a starting wager of $1. There is an equal probability that the coin will land on tails or head, and each flip of the coin is independent, meaning that the previous flip does not impact the eventual outcome of the next flip. As long as you stick with the same directional view each time, you would eventually, given an infinite amount of money, see the coin land on heads and regain all of your previous losses, plus an additional $1. The strategy is mainly based on the mathematical premise that only one trade (bet) is needed to turn your account around.
Let us assume that you have $20 to wager, starting with an initial wager of $1. You bet on heads, the coin flips that way and you win $1, bringing your equity up to $21. Each time you are successful with the bet, you continue to bet (trade) the same $1 until you lose. The next flip is a loser, and you bring your account equity back to $20. On the next bet (trade), you wager $2 with the hope that if the coin lands on heads, you will completely recoup your previous losses and bring your net profit and loss to zero. Unfortunately for you, it lands on tails again and you lose another $2, bringing your total equity down to $18. So, according to martingale trading strategy, on the next bet, you wager double the prior amount to $4. Fortunately, you hit a winner and gain $4, bringing your total equity back up to $22. As you can see, all you needed with the martingale strategy was one winner to get back all of your previous losses back and a little profit.
However, let us consider what happens when you hit a losing streak. Once again, you have $20 to wager, with a starting bet (trade) of $1. In this scenario, you immediately lose on the first bet (trade) and bring your balance down to $19. You double your bet on the next wager, lose again and end up with $17. On the third bet, your wager is up to $4 and your losing streak continues, bringing you down to $13. Next, you wager $8 and lost again bringing you account balance to $6. Now, you do not have enough money in your account to double down, and the best you can do in this situation is bet it all. If you lose, you are down to zero and even if you win, you are still very far from your initial $20 starting capital.
Forex Trading Application
You may think that the long string of losses, such as in the above scenario, would represent an unusually bad luck. But when you trade foreign exchange (currencies), they tend to trend, and trends can last a long time. The key with the martingale system, when applied to forex trading, is that by “doubling down” you essentially lower your average entry price.
Like we said above, you need a very deep pocket to be successful with the martingale trading strategy. If you only have $2,000 to trade, you would be bankrupt before you were even able to see the pair you are trading reach your mark. The currency may eventually turn in your favor, but with the martingale trading strategy, there are many scenarios when you may not have enough money to keep you in the market long enough to see that happen.
Why Martingale System Works Better with FX
One of the reasons the martingale trading strategy is so popular in the forex market is because, unlike stocks, foreign exchange rarely drop to zero. Although companies can easily go bankrupt, countries cannot. There will be times when a country’s currency is devalued, but even in cases of a sharp decline, the currency’s value never reaches zero. It’s not impossible, but what it would take for this to happen is too scary to even speculate.
The currency market also offers one unique advantage that makes it even more attractive for investors or traders who have the deep pocket (capital) to follow the martingale strategy: the ability to earn interest allows investors to offset a portion of their losses with interest income. This generally means that an astute martingale trader (forex investor) may want to only trade the strategy on currency pairs in the direction of positive carry. In other words, he/she would buy a currency with a high-interest rate and earn that interest while, at the same time, selling a currency with a low-interest rate. With a large number of lots, interest income can be substantial and could work to significantly reduce your average entry price.
The Bottom Line
As attractive as the martingale system may sound to some forex investors or traders, we emphasize that grave caution is needed for those who might want to practice this trading strategy. The main problem with this trading system is that often, seemingly sure-fire trades may blow up your trading account before you can turn a profit or even recoup your losses.
In the end, traders (investors) must question whether they are willing to lose most of their account equity on just a single trade. Given that they must always do this to average much smaller profits, many traders feel that the martingale trading strategy is entirely too risky for their tastes.