Vladimir Kruglov, CTO of PsyQuation, PhD, invites you to become a mathematician for five minutes to explain why you cannot fool the market and why the strategy employed by every other trader will in the end, almost always lead to an account blow up.
“This secret has been hidden from you for years!” “Win without fail” “A mathematical formula to provide you with a steady income!” – This is how Martingale strategies are typically marketed.
We however know from our research database that this strategy only works when viewed in “favorable” conditions. When you trade real money, in the real market, it has an annoying habit of ending in financial ruin. Martingale strategies are seen by a huge number of traders as the Holy Grail, says Vladimir.
The principle rule of the strategy is very simple. Let us use the toss of a coin at a casino to illustrate the point. You place a bet, Heads – you win a dollar. Tails – the casino wins a dollar. If you lose, you double the bet. If you lose again you increase your bet to four dollars, and so on, until you win and start a new round of bets – again with one dollar. In this way, at the end of each round if you win, you will always have exactly one dollar more than you had at the beginning. Let’s do the math.
-1, -2, -4 (total loss 7) + (win) 8 = 1 (profit)
-1, -2, -4, -8, -16 (total loss 31) + (win) 32 = 1 (profit)
Such calculations, hidden in marketing language, befuddle the brain and seem more impressive than worrying. A common marketing trick is to say that rich people are hiding this simple mathematical truth: you can also earn as many of these “plus-ones” as you would like and buy the house of your dreams. “You can’t lose” and in reality, you will not lose – Vladimir grins – “with one condition: that you have infinite capital”.
In fact, the money will run out much faster than you imagine. In the course of normal market conditions a situation will soon arise where a successive number of bets will go against the trader resulting in a bet that could be in the millions or even billions of dollars. Important to note these runs of bad luck are the rule rather than the exception.
Here a simple example of a Martingale strategy:
In the table below we have assumed that you have an account with $1,000 and that you have a mean reverting strategy that enters a EURUSD trade when the market hits an overbought or oversold threshold by moving 0.2%. With an initial position of 0.01 (micro) lot, how many successive losing moves of just 0.2% will it take before you blow up your account?
Martingale Blowup Table:
As you can see after just 6 trades, i.e. a mere 1.2% (0.2% x 6) move, you will have run out of margin and blown up your account.
We then built a tool to analyze probabilities of failure based on the number of trades in a week and their max hold time (72hrs) in our example.
Human psychology is what keeps people coming back for more, with the mistaken belief that these strategies are profitable. You see the win rate, that is the number of times the strategy has winners is usually very high. People become accustomed to an ever growing equity curve. You then start to really believe in your superior “talent”. Unfortunately it only takes one reasonable size move to be wiped out and your dreams to turn into a nightmare.
In the chart below you can see a typical martingale equity curve. The deep drawdowns are typically recovered with incremental profit gains to produce a smooth (PsyQuation does not hide these drawdowns by displaying intraday data curves) upward sloping end of day equity curve.
Unfortunately, the one who plays has to pay. Each new bid is far from free, but the trader whose thoughts are carefree with their “fireproof strategy”, tend to forget this uncomfortable truth with the inevitable drawdown blowup.
Typical Martingale Equity Curves
Think about it. To earn a dollar, you tend to do a lot of trades, which means commissions for these transactions can be quite high, as they increase in size with the length of the series before you close it with profits. Let’s assume it goes -1, -2, -4, -8, -16, +32, which means that 63 dollars pass through the account before you get your single dollar of profit but the gain does not increase – it is still the same maximum of one dollar. As a result, the commission becomes another hurdle to overcome.
Martingale Commission Trap Calculator
We decided to do a commission sanity check with quite shocking results. We found that after factoring the spread and commission of each trade that after only 4 trades going against you the commission will be equal to your profit target. Let us think about what that really means.
Using our example with a take profit target of $2. After only 4 martingale trades you will have already spent more money in commission than you had anticipated making from the trade in the first place. Now you know why brokers love Martingale traders.
Martingale Account Lifetime Comparison
Using a random database sample of 6,255 accounts we created 2 groups: non-Martingale and Martingale. Martingale trades were classified Martingale if the trade size increased by more than 1.6 times with each successive sequence.
It can clearly be seen that in the long run, traders who trade using the Martingale strategy collapse far more rapidly, with a lifetime less than half non-Martingale traders. This is partly related to commission causing a constant outflow of funds and the enormous risk that grows exponentially with each successive trade.
The Final Word
In our study, we looked at accounts with a position size growth of 1.6 times each new trade that have been put on less than 5hrs apart. We then look at the average profit per trade up to a maximum of 210 trades. You can see that Martingale underperforms non-Martingalers. This is done on a per trade basis.
In this study we look at account profitability based on being categorized as Martingale or not. Here the results are more dramatic than looking at trades on a per trade basis. We see exactly what we would expect. The more trades a Martingaler does the worse they perform.
If you are offered a way of “always winning”, think twice about it. Some people “hooked” on the Martingale strategy stop themselves out at a set limit of Martingale layers, say 4 layers. This can be a legitimate strategy if there is a genuine ability to identify market reversals. But after taking into account broker’s commissions, it is clearly a losing strategy for almost all Martingale traders. The classic strategy of “double until you win” does not work in the real world of finance – Now you know why!!!