Apparently, there’s a trading strategy that guarantees to make profits every time.
Seems way too good to be true, but that’s what the Martingale strategy claims.
Is this possible or is it just another failed theory?
Keep reading to find out.
The Martingale forex trading strategy is all based on probability. For those of you that love maths, you will enjoy reading about this strategy.
At its core, Martingale is based around mean reversion, so we will briefly explore this before going any further.
Table of Contents
- 1 Mean Reversion
- 2 What Is The Martingale Strategy?
- 3 Example Of Martingale Betting
- 4 Why Martingale Is Attractive To Forex Traders
- 5 Martingale Forex Strategy
- 6 Why Martingale Works Well With Forex
- 7 Know When To Double Down
- 8 Know When To Close Martingale Trades
- 9 Be Careful With Leverage
- 10 Does The Martingale Strategy Always Work?
- 11 Hedging
- 12 Benefactors Of Martingale
- 13 Pyramiding
- 14 Conclusion
Mean reversion theory forms part of a statistical analysis of current market conditions, which are to be incorporated into a trading strategy.
In the diagram above, the red line represents the mean. The black line shows the trend oscillating above and below the mean. Once it moves above the average it regresses (ie reverts) back towards it.
The MACD can be a useful tool for defining the mean.
In terms of forex, mean reversion suggests that currency prices will always return to the historical average.
For example, the oldest and most common theory of all (buy low, sell high) applies to the mean reversion theory. Traders invest in low prices in the hope, or prediction, that the prices will return to their higher values.
So now we know a bit about mean reversion theory, let’s apply it to the Martingale strategy.
What Is The Martingale Strategy?
As introduced by French mathematician Paul Pierre Levy, the original Martingale was used as a way to ‘double down’ on a casino bet.
However, this was taken further by American mathematician Joseph Leo Doob. His system comprised of laying a bet twice the size of the previous one if it lost.
The theory was that, given enough time, just one win will make up for the previous losses, essentially meaning that the system would be 100% profitable.
Imagine applying this to a roulette wheel without the 0 or 00; it would be a straight 50/50 split between red or black.
Let’s run through how to see how this would work:
Example Of Martingale Betting
Imagine we had a bankroll of $100 and we start gambling the ball on the roulette wheel will land on red for every bet.
In terms of probability, each spin is an independent event, meaning that the previous result has no impact on the next.
For the first spin, we bet $10 that it lands on red. After the ball lands, we find that it does indeed land on red, so we win the bet. The payouts on red/black are even so we profit our original stake, $10. The bankroll is now at $110.
For the next spin, we also bet it lands on red, staking another $10. However, this time it lands on black, so we lose. The bankroll falls back to $100.
Martingale theory now suggests that we now bet $20 on the next spin to recoup our losses. However, once again it lands on black so the bet loses. The bankroll is now at $80.
Once again, Martingale theory says we should bet $40 on the next spin. Luckily, the result comes in our favour, winning $40. This puts our bankroll up to $120.
As you can see, we only needed to win this one spin to get back all our losses and make a profit.
Here is a summary of our results:
|Red||$ 10||Red||$ 10||$ 110|
|Red||$ 10||Black||$ (10)||$ 100|
|Red||$ 20||Black||$ (20)||$ 80|
|Red||$ 40||Red||$ 40||$ 120|
The Martingale strategy is the precise reason why the two green numbers, 0 and 00, were introduced to the roulette wheel. This ended up killing the Martingale strategy for this particular game.
What If We Keep Losing?
This is one of the big disadvantages of the Martingale strategy. Without a deep bankroll, it can be easy to make large losses.
Let’s see what this looks like using the previous example:
|Red||$ 10||Red||$ (10)||$ 90|
|Red||$ 20||Black||$ (20)||$ 70|
|Red||$ 40||Black||$ (40)||$ 30|
|Red||$ 30||Red||$ ?||$ ?|
Like before, we place a $10 wager on red. However, it lands on black and so we lose. The bankroll is now at $90
Martingale says we must now double down, so we now bet $20 on the next spin. This bet also loses and so the bankroll is now at $70.
Once again, we have to double down so the next wager is $40. Unfortunately, this also loses, leaving the bankroll at $30.
Now, we don’t have enough money to double the previous bet so we are all in. At this point, we are in a lose/lose situation. If we lose, the bankroll is $0, if we win, we are $60, far short of the original $100 bankroll.
So as you can see, if your pockets don’t dig deep enough, there is a risk you can lose a lot.
Why Martingale Is Attractive To Forex Traders
Firstly, if the conditions are right, Martingale strategies offer what appears to be a predictable profit outcome and a “sure bet” on eventual wins. In essence, Martingale does not rely on any predictive ability.
You can potentially make money from this strategy based purely on mathematical probabilities over time. Traders believe they can replace their own underlying knowledge and experience in particular markets.
In particular, Martingale is popular with beginners to forex trading because they can work when their ability to choose correct trades is just pure chance.
Also, currency pairs trade in ranges over fairly long periods of time, so the same price levels are often revisited many times. As with “grid trading,” there are usually multiple entry and exit possibilities in the trading range.
It’s important to understand from the beginning that a Martingale forex strategy doesn’t improve the chances of winning a given trade, and its major benefit is that it delays losses. The hope is that losing trades can be held until they become profitable again.
Martingale strategies are based on cost-averaging. The strategy means doubling the trade size after every loser until a single winning trade occurs. At that point, because of the mathematical power of doubling, the trader hopes to exit the position with a profit.
And by “doubling” the exposure on losing trades, the average entry price is lowered across all entry points.
Martingale Forex Strategy
So now we know how it works and why forex traders love using it, let’s now see how it works.
Currencies experience trends that can potentially last a long time. For example, during periods of political uncertainty, the prices can continue falling until it’s resolved.
This removes a lot of the ‘bad luck’ element, which is obviously prominent in most casino games.
The reason why Martingale is guaranteed to eventually make a profit is that when you double down, the average entry price is lowered.
Let’s run through an example to show this in practice.
Imagine we are trading on GBP/USD. We enter the market of 1 lot at 1.3100. The price falls to 1.2990, losing 20 pips in the process. At this point, it reaches our ‘virtual stop loss’
We say ‘virtual’ because it makes no sense to close the current trade and open another for twice the size. Instead, we add a new trade on the existing one and double the size.
A 1.2990, the average entry price then becomes 1.3000. The price is the same but we need a retracement of +10 pips rather than the 20 as the previous trade.
Here is a summary of what our trade could look like:
|GBP/USD entry price||Lots||Average/break-even price||Accumulated loss (pips)||Bankroll +/(-)|
When the entry rate reaches 1.2968, it reaches our break-even price.
The trade can then be closed once the rate is at or above this level. The previous three trades made losses but they were covered by the profit in the last trade.
You would then proceed to go back to using 1 lot for the next trade and the cycle repeats.
Our graph would have looked something like this:
Why Martingale Works Well With Forex
Unlike other markets like stocks and shares, forex prices rarely hit zero. Picture it like this: businesses can fail and go bankrupt with ease, whereas countries cannot.
There may be times when a currency devalues dramatically, but even in these extreme circumstances, the price does not hit zero. Don’t get us wrong, it’s definitely possible for a currency to hit zero, but for this to happen, the world’s economy must have screwed up.
For those that have a large bankroll to take advantage of this strategy, interest can be earned to offset some of the losses. This may encourage some traders to only buy currencies that have a high-interest rate, earn the interest and sell currencies with a low-interest rate at the same time.
With a large number of lots, interest income can be very substantial and could possibly be used to reduce the average entry price.
Know When To Double Down
This whole strategy is based on doubling down, so knowing when to do it is key. Remember, the “virtual” stop loss assumes the trade has gone against the original direction.
If the double down is too small, too many trades will be open. Too big and it undermines the entire strategy.
The values for the stops and profits should ultimately depend on the time-frame being trading and the market’s volatility. In general, use smaller stop losses in lower volatility.
Know When To Close Martingale Trades
Martingale trades should only be closed when the whole process is profiting. The Martingale strategy requires consistently treating the set of trades as a group, not independently.
It’s best to take smaller profits of around 10-50 pips.
This is because smaller take profits have a higher probability of being reached sooner, making it better to close while the system is profitable.
Also, profits compound because the lots traded increase exponentially, so a smaller value can still be effective.
As we mentioned earlier, there is also the interest to consider. Smaller profits here enable you to maintain an increasing bankroll, making even more on the growing interest.
Smaller take profit levels don’t alter the risk/reward ratio. Yes, the gains will be lower, but the nearer win-threshold improves the overall trade win-ratio.
Be Careful With Leverage
In general, leverage is an attractive feature of forex trading. However, with Martingale, leverage can become a danger if not managed correctly.
Most brokers supply substantial leverage, meaning even the smallest movements in a currency pair might also drive substantial losses. Some brokers can offer leverage at 500:1 or more but even 50:1 can do damage to a bankroll.
Does The Martingale Strategy Always Work?
In theory, yes.
Pure Martingale systems can theoretically produce a sequence of trades that never lose. If the price falls, just double down.
However, practically, it will never work as well. You will need an endless supply of money, which is highly improbable.
In a live trading system, you are required to set a drawdown limit. Once you pass this limit, the trade closes and recorded as a loss.
When you restrict the ability to drawdown, you start moving away from a theoretical Martingale system. In doing so, you’re using an approximation that will always fail at some point.
The greater your drawdown limit, the less likely it is you’ll make a loss. However, the flip side to this is that if you do lose, the loss will be bigger.
The more trades you enter, the more likely the extreme odds will come up. If you’re unfortunate to be on the wrong end, a long string of losses will wipe out your bankroll. As we know from a previous article, trading with a small bankroll is less than ideal.
Going back to the mathematics, in a sequence of N Martingale losing trades, your risk exposure increases as 2N-1.
On the other hand, profits made from winning trades only increase linearly. In fact, it’s proportional to half the profit per trade (B) multiplied by the total number of trades(N).
This can be represented by the following equation:
E ≈ 1/2NB
For example, let’s say we have a 5 double down limit. Then our biggest trade would be the 32nd.
We would only lose this amount if we had 6 losing trades in a row. The probability that this happens is 1/26, ie we will lose once every 32 trades.
But, a big one-off losing trade will set this back to zero, so the odds will always remain 50/50. The risk/reward ratio is also evenly balanced but any losses will come in one large sum.
If you’re unlucky at the beginning of your trading session, the losses will seem a lot worse than they actually are.
This system is a bit different and often used by manual traders. The idea is that after you enter the market and it moves against you, you would enter with double the size … in the opposite direction.
This is the equivalent of closing your initial position and opening a new one, following the market move (or flipping). The idea is to keep all positions open and eventually decide when to close the winning trades.
What do you do with the losers? Well, you wait for them to retrace or close them at smaller losses than your closed winners.
This is definitely a more advanced technique and requires more judgment than normal Martingale strategies. Although it appears to benefit from market trends it does carry some of the risks involved with the previous two.
Benefactors Of Martingale
Martingale trading is suited to traders that are able to tolerate risk and have enough capital to deal with potentially large losses.
Operating on a small scale as part of a wider portfolio Martingale strategies can be effective, but they can also quickly become a money pit on days when you seem to be having no luck at all.
If you are a trader that acts on the more cautious side, this strategy is not for you. It’s also not suitable for those looking like to conserve their capital. There is a real risk that your entire bankroll can be wiped out, threatening your entire trading career.
The biggest takeaway from this is to make sure you can afford to lose what you trade before implementing Martingale.
Some people dislike Martingale because it looks to make profits from losing positions.
After all, if a position is declining, surely that says something about your market analysis, right? So, why then double down on what seems to be a previous bad decision?
Would it not be more logical to double down on a winning position?
If you have read this article and thought this, then pyramiding could be the strategy for you. This method is also known as scaling into position.
The general rule for this strategy is only adding to a winning position – the complete opposite to Martingale!
When done properly, there is less exposure to any additional risk. In fact, you are actually mitigating your risk as the trade moves in the direction you want.
How Pyramiding Works
Imagine GBP/USD in on an uptrend and one of your strategies gives you a buying signal.
You would first enter a buy trade with 1 contract, place a stop loss. Your trading system would then give you a signal to buy, so you buy another contract. As always, each buy requires a stop loss so you place this too.
From here, you move the second stop loss of the first trade to the exact same level where the second stop loss was made. By doing this, there is only one risk, which is one the second trade.
When you see another buy signal, enter the third trade and place another stop loss. So now, you have to move the trailing stop losses of the first trade as well as the second trade and place it at the level where the stop loss of the third trade was placed.
In that way, the first trade has locked in a lot of profits now, the second trade has zero risks, with all risk placed on the third trade.
Here is a basic example of what pyramiding looks:
The above example shows a clear uptrend, going higher highs and higher lows. This pattern is easily breaking resistance and then retesting as a new support.
These conditions are ideal for pyramiding trades.
The first buy order was triggered when the market retested the former resistance as a new support. The next two buy orders were executed on the same basis.
If you were to pyramid on this particular trade, you may have spotted the potential for a fourth buy order shortly after the third.
Just bear in mind that the market must break through each level and then show signs of holding before doubling down. This is why confirming the strength of the trend is vital to effective pyramiding.
For traders implementing the Martingale forex trading strategy, take caution. At first, it may seem like a guaranteed profit-making machine, but without a deep bankroll, it can blow up quickly.
Pyramiding may be a better option as it makes the most of winning positions rather than its counterpart.
Thanks for reading.