The Martingale system has long been utilized as a betting strategy, originating in France during the 1700s. Initially used across table games on casino floors, it would later be intertwined with the concept of probability theory by another Frenchman named Paul Pierre Levy.
The Principles of the Martingale system for financial investing
The primary focus of the Martingale system was on games of chance, especially roulette. In fact, it’s still one of the most common betting strategies used to try and win at roulette online, alongside more complex approaches like the Fibonacci strategy and the D’Alembert strategy. That’s because it’s one of the easiest to understand and use from day one.
The fundamental principle of the Martingale system for financial investing is crystal clear. You must double your bet size after every loss to ensure that, when you do win, you’ll recoup all previous losses and gain one unit of profit. This approach is only useful on even-money roulette bets, where the chances of winning are as close to 50/50 as possible.
Let’s say, for example, that you wager $5 on the next roulette spin being red. The outcome is a black number. The next spin, you wager $10 on red. The outcome is black once again. The following spin, you wager $20 on red. This time, the outcome is red, earning you a $20 return on your $20 stake – one unit of profit up on your previous losses.
If you’re thinking ‘This sounds interesting, is it applicable to financial investing?’, read on as we explain how it could be used in the financial markets, as well as the inherent drawbacks of the system.
In the context of financial investing or day trading in the markets, the Martingale system could be used across various asset classes. If you’re an equities trader, you may decide to double the size of your investment in a specific stock after a percentage fall in price, in the hope that the share price will rebound over time. This would continue to lower your entry point, but the issue is you’d be magnifying your potential losses too.
You could achieve similar in the forex market and even in options trading, doubling down on options contracts after a losing trade, in the anticipation of a market reversal.
Ultimately, the best way to use the Martingale strategy in the financial markets is when you trade with a 1:1 risk-reward ratio. Using this ratio, it’s as close as you’ll get to the effects of using the Martingale system for financial investing on outside bets at a roulette table.
Let’s say you trade with a risk-reward ratio of 1% of your trading bank to win 1%. If the trade ended up losing you 1%, you could double your risk to the same ratio for the next position. Effectively, you’d risk 2% to win 2%. If the position moves in your favor, you’d close the trade for a 1% return over the two trades.
The Elephant in the Room
Aside from the potential loss recovery benefits of the Martingale strategy and the structured, systematic approach, there are plenty of drawbacks to the strategy. To ensure you understand the pros and cons of Martingale, we’ll discuss the pitfalls in similar detail to help you decide if it’s a system for you.
Undoubtedly, the biggest red flag of the Martingale system for financial investing is the threat of racking up exponential losses. Although you may have a clearly defined risk management plan of risking 1% or unit to win 1% or unit, there’s nothing that says you can’t suffer prolonged losing streaks in the market. Using the Martingale system for financial investing, you only need six losing trades in a row to be suddenly risking a third (32%) of your bank to try and recoup your losses.
The reality is that long losing runs can and will happen, just like you’ll enjoy lengthy winning runs in the markets too, so long as you’re disciplined and have a long-term edge in the market.
Can you deal with the psychological pressure that comes with suffering sustained losing streaks and having to risk even more to win it all back? Human emotion is one of the biggest risks in the financial markets. It can cloud your judgment, leading to poor decision-making.
If you trade with a financial broker, it’s possible that your broker will trigger a margin call after multiple losses, especially on the same asset. You may need to deposit more money into your trading account just to sustain your open positions.
On the surface, the Martingale system for financial investing seems a refreshingly simple way to structure your trades and recover losses. However, the multiple risks such as dependence on exponential capital allocation and the incorrect assumption that the market always corrects itself outweighs the modest advantages to the system. Ultimately, any financial investor should hone their own trading strategies and implement robust risk management principles to protect and grow any trading banks.
