The use of Martingale systems can be traced back to 18th Century France, when French mathematician Paul Pierre Levy introduced the system to the general populace. However most of the early work on Martingale systems was completed by American mathematician Joseph Leo Doob, who sought disprove the possibility of a foolproof betting system. For a brief period of time martingale strategies became incredibly popular among French gamblers as the system boasted a near hundred percent success rate provided a gambler had infinitely deep pockets.
Martingale systems were developed for many simple gambling games such as heads or tails and roulette. Not so long ago there was a re-emergence of Martingale systems when many sought to profit of the rise of online casinos by selling or promoting such strategies. While Martingale systems are typically associated with various forms of gambling some traders have adopted martingale systems often with a disastrous outcome.
In a simple game of heads or tails a gambler guesses either heads or tails, if his guess is correct he doubles his money. A Martingale system would have the gambler double his bet after every loss, so that our gambler would recover all of his losses and win a profit equal to his original stake. Assuming there is an equal probability that the coin will land on heads or tails and the gambler has an infinite amount of money, there is no chance the gambler will lose. Since his infinite wealth will mean that the coin will eventually land in his favour, meaning he will recover all his loses and make a profit equal to his stake.
The below example demonstrates a good run using a Martingale system:
In the above example our gambler doubled his initial Balance of 100 to 200 in only seven bets. It should be clear how risky such a strategy is, at one point the gambler bet 80 when he had a balance of 120. You should see that all it takes is one winner to get all of your funds back.
Due to the fact that no gambler has an infinite bankroll and with the bet size growing at an exponential rate, it will only take one or more unlucky choices to bankrupt the gambler. It has been suggested that martingales systems are a good example of Taleb distribution with the system appearing to offer steady returns and limited risk but on occasion experiences a huge or fatal drawdown.
The example below demonstrates how a small run of losses can lead to a gambler going broke.
Use In Trading
While many would think three loses in the row to be simple bad luck, trends in trading tend to last for an extended period of time. Those who adopt martingale strategies ‘double down’ when their position moves against them. This lowers your average entry price and means that you need a smaller reversal to make a profit, of course piling on an increasing number of lots vastly increases your exposure. The example below shows how using a martingale system can lower your average entry price;
While the above shows how by ‘doubling down’ can lower the average entry cost and allow a trader to break even from a relatively small price reversal. It should also be clear how using such a martingale could quickly bankrupt a trader, from trading an initial 0.1 lot the trader ends up accumulating a loss of $630 likely to be larger than the entirety of his account. In fact the situation is worse than in the above example which doesn’t take account of the cost of trading. Add spreads and commission on top of these figures and the situation is much bleaker.
A surprising number of traders use martingale systems. While currency prices do fluctuate currencies rarely ever hit zero, this fact means it’s unlikely that the price will move in one direction indefinitely. Significant price fluctuations do in fact occur and these fluctuations could lead to a trader receiving a margin call before a price reversal does occur. Some traders only use a martingale strategy when they can take advantage of a positive swap rate. Having a large open position allows them to earn significant interest while they await a price reversal.
Martingale systems are extremely risky and should be avoided, small price movements against a trader can result in massive drawdowns. Many of those who have put their faith in martingale strategies have ultimately lost a significant sum of money, when the market continued to move against their open positions.