The history of the financial market is littered with multiple traders who used different strategies to make money. In the 30s, Jesse Livermore used a simple price action strategy to make a fortune. In the 50s, Warren Buffet started his investment company with a long-term view. Today, the company has a market capitalisation of $516 billion. In the 80s, James Simmons introduced the concept of algorithmic trading. Today, he is worth more than $18 billion. At the same time, Steve Cohen built a personal fortune of more than $11 billion by insider trading while Carl Icahn built a fortune of more than $16 billion by being a corporate trader.
These examples show how diverse the capital market is and how people have used different methods to make money. Thousands of other strategies are used every day by traders from around the world. Some of these methods like value investing and price action trading have been widely accepted. Others like the Martingale trading strategy are more controversial.
What is the Martingale strategy?
This is an old strategy developed by French mathematician Paul Pierre Levy. Paul was a famous French mathematician who laid the foundation for several probability theories like the local time, stable distributions and characteristic function.
Originally, the concept of his Martingale strategy was applied in the gambling industry. To this day, many casinos have applied his ideas to introduce betting minimums and maximums. It has also been applied in the design of the roulette wheels, which have two green markers in addition to the odd or even bets.
The strategy is based on the mean reversion ideology. According to it, a trader or gambler doubles down on a losing bet. For example, if you place a bet worth $10 and lose, the strategy recommends that you place another bigger bet. If this one loses, you initiate another bigger one. With mean reversion, the strategy assumes that at a certain point, the losing streak will reverse and that the losses will be covered by the bigger win.
Martingale strategy in trading
Financial securities move up and down every day. As they move, the securities create patterns, which include pullbacks. When a trader initiates a trade, their aim is to benefit from a trend. When they open a buy trade, their aim is to benefit from an upward trend and, when they sell, their aim is to benefit from the declining price. The most profitable trades are those which are in line with the trend.
Since the market involves risks, these trends are difficult to identify. This is why even the best traders in the world make occasional losses. When this happens for a trader using the Martingale approach, they double down on the trade.
If the original trade was to buy 0.01 lots of the EURUSD, the trader would then buy 0.02 lots. If the second trade makes a loss, the trader would buy another lot of 0.04, and if that trade loses, they double down by buying 0.08 lots. The assumption is that if the final trade makes a profit, it will cover the previous losses. The size of the lot and the price of the security, therefore, becomes better for the trade.
The approach is also based on the cost averaging method. In this method, a trader or investor doubles down on the trades when their price is moving against them. For example, assume that you have bought the stock of Daisy, LLC at $50. After a few days, an investment bank releases a report downgrading the stock, which causes the stock to fall to $40. You can decide to exit the investment with a $10 loss. However, if you believe in the company, you can continue buying the stock. If the stock recovers, you will make a bigger profit.
A good example of this is when Bill Ackman—a prominent hedge fund manager—bought the stock of restaurant chain, Chipotle Mexican Grill at $410 in 2016. A few months after buying, the stock rose to $500 before starting to fall. It reached a low of $250 in early 2018. During this time, his fund bought more shares. In the first quarter of the year, the stock started moving up, and by August, it was trading at $520. As a result, the investments he made at $250 were more profitable than the initial investment.
Risks in trading with the Martingale strategy
The Martingale approach to trading comes with a few risks and should, therefore, be used carefully. This is because the trend of security could continue to fall, which would lead to more losses. A good example of this is what happened in the gold market in 2018. In April, the price of gold reached a high of $1,365. It then started falling and reached a low of $1,160 in August. Therefore, traders who were bullish on gold and continued to double down made big losses because the trend did not reverse.
Another example is with Bill Ackman again. A few years ago, he invested in a company called Valeant Pharmaceuticals when the stock was at $150. After a few months, the stock rose to $250 and then started to fall. As it continued to fall, he bought more hoping that the stock would recover. In 2017, he was forced to exit the investment with a $4.4 billion loss.
Does this strategy work for you?
The Martingale trading strategy is quite controversial among traders. When used well, it can help you recover losses and trade effectively. However, when things go wrong, the losses can add up. Therefore, it is recommended that you take time to learn and practice it using a demo account, ensure you have a healthy account balance and have your risk management strategies in place.