If there is one trading system or approach that tends to spark fierce conflict within the trading community, then perhaps nothing comes as close as the Martingale trading method. It is perhaps due to the fact that the Martingale approach to trading is based on probabilities and chance than anything else. So what is this martingale trading method and should you be using it? Read this article to form your own opinion.
What is Martingale?
Martingale is a probability theory of fair game which was developed by a French mathematician, Pierre Levy in the 18th century. Without getting too technical, from a trading perspective, Martingale approach involves doubling up every time a loss is incurred. Taking the example of a simple heads and tails of the coin flip, in a Martingale approach, every time there is a loss, the next bet is doubled, in hopes to recover the losses as well as gain one up from the loss.
As you can see from the basic definition of Martingale, it can be a very profitable yet very risky way to trade the financial markets. The Martingale approach of trading is more popular with gambling, especially with Roulette where the chances of hitting a Red or Black are 50 – 50.
So, to define Martingale from a forex trading approach, it is nothing but a process of cost averaging, where the exposure is increased (doubled) on losing trades.
Despite the risks posed by Martingale trading method, there are a good number of followers to this trading strategy. It is probably best to illustrate the Martingale way of trading with a simple example.
Remember, that we double down (or double our bets) during a losing trade. For this example, let’s assume a trader has $100 in equity and risks not more than $10 trading the EURUSD.
Explaining the above table:
From the above table, it is now easier to understand that if the trader hit a series of losing trades, their equity would have been burned out. Which brings to question, what happens if you use the Martingale trading strategy to a currency pair or instrument where there is a clearly established trend? Of course, in this case, the results would awesome. However, such an approach is also not void of risks. In essence, it is governed by how close your stop loss is, or the amount you are willing to risk/lose should the trade turn against you.
Let’s look at the Martingale trading strategy with another example.
EURUSD is currently at 1.30.
|POSITION||LOTS||ENTRY PRICE||CURRENT PRICE||P/L|
In this example, notice how the trade entry was doubled every time price dropped by 5 pips. While the total risked amount was -$15, when price moved back to 1.2995, the $20 gain managed to make up for the loss and also gives the trader a $5 extra.
But the above illustration is a best case example. Imagine if the trend had changed and the EURUSD suddenly started to drop lower. In such an event, the Martingale way of trading would have greatly drained the trader’s equity.
The important take-away from the above example, is the price move itself. Ideally if a trader went long at 1.3 and price dropped to 1.2995, it would have resulted in a -$5 equity drawdown. However, thanks to the Martingale approach, despite the price was lower than the first entry, the 5 pip move managed to convert the trade into a winning trade while at the same time increasing the equity by $5 despite the price being 5 pips lower than the initial entry.
The Martingale way of trading forex, in theory works. However, for this to happen, traders need to have an unlimited equity, which is something that doesn’t quite work in the real world.
Using Martingale (or doubling down) within your analysis
While the pure martingale trading system is something that is not advisable for equities of less than $5000, the approach of doubling down can be applied to increase the profits within the structures of a pre-determined trading system.
But for this to happen, traders need to have a very high level of confidence and experience trading the forex markets. Look at the example below: Here, we apply a simple price action scalping strategy of the trend line break method.
After a first short position was initiated near the low of the candle formed below 38.2%, price moved against the bias.
After a 10 pip move against the initial trade (trade #1), the second trade is initiated with 2 lots (doubled from the previous 1 lot trade). With the target price for both the trades being the same, the results are vastly traded.
The risks of course for such an approach would be different, compared to a simple approach to trading. Assuming the stops for the short trade was at 1.02, the risk with the first trade would have been $27, whereas with the martingale’s way of doubling down, there would have been an additional risk of $34
It is easy to understand that while Martingale trading method can potentially increase the profits, the risks are also equally the same. Very high risks! In order to be successful with trading the martingale approach, traders need to have a good risk management strategy in place along with a firm background in technical analysis and familiarity with a trading system that they use.
Read here our helpful article Safe martingale and manual trading