Martingale Strategy: Understanding Risk & Application

The Martingale Strategy involves doubling the trade size every time a loss is faced. A classic scenario for the strategy is to try and trade an outcome with a 50% probability of it occurring. The scenarios are also called zero expectation scenarios.

For a situation with an equal probability, such as a coin toss, there are two viewpoints about how to size a trade. The Martingale Strategy states that one must double the size given a loss. The theory behind the strategy is that you regain whatever’s been lost. Similarly, an anti-Martingale Strategy states that one must increase the trade sizeVolume of TradeVolume of trade, also known as trading volume, refers to the quantity of shares or contracts that belong to a given security traded on a daily basis given a win.

Summary

• The Martingale Strategy is a strategy of investing or betting introduced by French mathematician Paul Pierre Levy. It is considered a risky method of investing.
• It is based on the theory of increasing the amount allocated for investments, even if its value is falling, in expectation of a future increase.
• When the Martingale Strategy is used in betting, the gambler must double the bet when faced with a loss.  

Understanding the Martingale when there are Two Outcomes

To understand the topic better, consider a trade with two outcomes with equal probability, Outcome 1 and Outcome 2. Trader X decides to trade a fixed sum of $50, hoping for outcome 1 to occur. However, Outcome 2 occurs instead, and the trade is lost.

Using the Martingale Strategy, the trade size is increased to $100, again hoping for Outcome 1. Again, Outcome B occurs, and the $100 is lost. As it’s a loss, the trade is doubled and is now $200. The process is continued until the desired outcome is achieved.

As you can see, the size of the winning trade will exceed the combined losses of all the previous trades. The difference is the size of the original trade size.

Examples

Some possible sequences of the above example:

• Win the first trade and make a profit of $50
• Losing the first trade and winning the second trade:

– Lose $50 on the first trade and win $100 on the second trade. You are left with a $50 net profit.

• Losing the first two trades and winning the third trade:

– You lose $50 on the first trade, $100 on the second trade, and then win $200 on the third trade. It leaves you with a $50 profit again.

• Losing the first three trades, but then winning the fourth trade:

– You lose $50 on the first trade, $100 on the second trade, and then $200 on the third trade. However, you win $400 on the fourth trade. Again, you are left with a $50 profit.

Using the Martingale Strategy in the Stock Market

The Martingale Strategy is usually used in any game with an equal probability of a win or a loss. It is important to understand that markets are not zero-sum gamesZero Sum Game (and Non Zero Sum)A zero sum game is a situation where losses incurred by a player in a transaction result in an equal increase in gains of the opposing player. Markets are not as simple as betting on a roulette table. Therefore, the strategy is usually modified before it is applied to stock markets.

Consider the following example. A trader uses the Martingale Strategy and makes a purchase of $10,000 worth shares of a company when it is trading at $100. Assuming that the stock price falls in the next few days and the trader makes a new purchase worth $20,000 at $50, the average goes up to $60 per share.

Suppose the stock price falls further, the trader makes another purchase worth $40,000 at $25. It takes the average cost per share to $33.33. At this point, as per the strategy, the trader can successfully exit the trade and make a profit equal to the initial bet size at $38.10. The trader then waits for the stock to move to $38.10 and makes a gain of $10,000, which is the size of the initial bet.

In the above case, the trader could exit after the third bet as the stock price reached $38.10. It does not always happen, and the trade size can reach extremely high amounts in case the stock price falls for a long period of time. In the hope of recovery, a lot of money is put at stake using the strategy.

Drawbacks of the Martingale Strategy

• The amount spent on trading can reach huge proportions after just a few transactions.
• If the trader runs out of funds and exits the trade while using the strategy, the losses faced can be disastrous.
• There is a chance that the stocks stop trading at some point in time.
• The risk-to-reward ratio of the Martingale Strategy is not reasonable. While using the strategy, higher amounts are spent with every loss until a win, and the final profit is only equal to the initial bet size.
• The strategy ignores transaction costsTransaction CostsTransaction costs are costs incurred that don’t accrue to any participant of the transaction. They are sunk costs resulting from economic trade in a market. In economics, the theory of transaction costs is based on the assumption that people are influenced by competitive self-interest. associated with every trade.
• There are limits placed by exchanges on trade size. Therefore, a trader does not receive an infinite number of chances to double a bet.

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