Forex Trading the Martingale Way

Would you be interested in a trading strategy that is virtually 100% profitable? Amazingly, such an approach exists and dates back to the 18th century. The martingale strategy is based on probability theory. If your pockets are deep enough, it has a near 100% success rate.

The martingale strategy was most commonly practiced in the Las Vegas casinos. It is the main reason why casinos now have betting minimums and maximums. The problem with this strategy is that you need a significant supply of money to achieve 100% profitability. In some cases, your pockets must be infinitely deep.

A martingale strategy relies on the theory of mean reversion. Without a plentiful supply of money to obtain positive results, some trades will be missed, and that can bankrupt the entire account.

In fact, the risk is far higher than the potential gain. Still, there are ways to improve the martingale strategy that can boost your chances of succeeding.

What Is the Martingale Strategy?

The martingale was introduced by French mathematician Paul Pierre Levy and became popular in the 18th century. The martingale was originally a betting strategy based on the premise of "doubling down."

The 20th-century American mathematician Joseph Leo Doob continued work on the martingale strategy. However, he sought to disprove the possibility of a 100% profitable betting strategy.

How It Works

The system's mechanics involve an initial bet that is doubled each time the bet becomes a loser. Given enough time, one winning trade will make up all of the previous losses.

The 0 and 00 on the roulette wheel were introduced to break the martingale's mechanics by giving the game more possible outcomes. The long-run expected profit from using the martingale strategy in roulette turned negative, discouraging players from using it.

To illustrate the mechanics, suppose we had a coin and engaged in a game of heads or tails with a starting wager of $1. There is an equal probability that the coin will land on heads or tails. Each flip is an independent random variable, which means that the previous flip does not impact the next flip. If you doubled your bet every time you lost, you would eventually win and regain all of your losses, plus $1.

The strategy is based on the premise that only one trade is needed to turn your account around.

Examples of the Martingale Strategy in Action

Assume that you have $10 to wager, starting with the first wager of $1. You bet on heads, the coin flips that way, and you win $1, bringing your equity up to $11.

Each time you are successful, you continue to bet the same $1 until you lose. The next flip is a loser, and you bring your account equity back to $10.

On the following bet, you wager $2 to recoup your previous loss and bring your net profit from $0 to $2. Unfortunately, it lands on tails again. You lose another $2, bringing your total equity down to $8.

Pursuing the martingale strategy, you double your wager to $4 on the next bet. Thankfully, you hit a winner and gain $4. That brings your total equity up to $12. All you needed was one winner to get back all of your previous losses.

However, let's consider what happens when you hit a losing streak:

You once again have $10 to wager, with a starting bet of $1. In this case, you immediately lose on the first bet and bring your balance down to $9.

You double your bet on the next wager, fail again and end up with $7. On the third bet, your wager goes up to $4.

Your losing streak continues, bringing you down to $3. You do not have enough money to double down, and the best you can do is bet it all.

You then go down to zero when you lose, so no combination of strategy and good luck can save you.

Application to Trading

You may think that a long string of losses, such as in the above example, would represent unusually bad luck. But when you trade currencies, they tend to trend, and trends can last a long time. The trend is your friend until it ends.

The key with a martingale strategy, when applied to the trade, is that by "doubling down" you lower your average entry price. In the example below, at two lots, you need the EUR/USD to rally from 1.263 to 1.264 to break even. As the price moves lower and you add four lots, you only need it to rally to 1.2625 instead of 1.264 to break even.

The more lots you add, the lower your average entry price. You may lose 100 pips on the first lot of the EUR/USD if the price hits 1.255. On the other hand, you only need the currency pair to rally to 1.2569 to break even.

This example also provides a clear example of why significant amounts of capital are needed. If you only have $5,000 to trade, you would be bankrupt before you could see the EUR/USD reach 1.255. The currency should eventually turn, but you may not have enough money to stay in the market long enough to achieve a successful end.

That is the downside to the martingale strategy.

Why Martingale Works Better With Forex

One of the reasons the martingale strategy is so popular in the currency market is that currencies, unlike stocks, rarely drop to zero. Although companies frequently go bankrupt, countries rarely do.

There will be times when a currency falls in value. However, even in cases of a sharp decline, the currency's value rarely reaches zero.

The FX market offers another advantage that makes it more attractive for traders who have the capital to follow the martingale strategy. The ability to earn interest allows traders to offset a portion of their losses with interest income. That means an astute martingale trader may want to use the strategy on currency pairs in the direction of positive carry.

In other words, they would borrow using a low-interest-rate currency and buy a currency with a higher interest rate.

The Bottom Line

As attractive as it may sound to some traders, using the martingale method can be disastrous. Seemingly surefire trades can blow up your account before you can profit or even recoup your losses. In the end, traders must question whether they are willing to lose most of their account equity on a single trade.

Given that they must do this to average much smaller profits, it's wise to conclude that the martingale trading strategy offers more risk than reward.