Various strategies and trading systems are applied in trading on financial markets. Most of them are based on preliminary analysis of price behavior and volumes to generate signals for making trades. However, some traders believe that profit can be achieved without putting effort into learning and gaining experience. Among such market participants, a strategy involving the incremental scaling of positions until a positive result is achieved is quite popular. They rarely question whether the Martingale method can be used in trading.
From this article you will iearn:
- The Martingale method requires constant position size increases, leading to significant drawdowns and diminishing returns, making it impractical without substantial funds.
- Using leverage exacerbates the risks, increasing both potential profits and losses, which can quickly deplete the trader’s account.
- The Martingale method fails in spot trading, futures trading, and binary options due to its inherent risks and the structure of these markets, often leading to complete account depletion.
The Martingale Method in Financial Markets
The Martingale method originated from gambling, where it is often used in casinos. Its essence is simple:
- A game with equal probable outcomes is chosen, for example, betting on red or black at the roulette table.
- An initial bet is placed on any of the outcomes.
- If the bet loses, it is repeated with double the initial amount.
- The process repeats until the player wins.
It’s easy to calculate that, with a successful outcome, the player wins an amount that compensates for losses from all previous rounds, plus a profit equal to the initial bet.
Many financial market researchers assert that asset price behavior is unpredictable, and at any given moment, the probabilities of rising and falling are equal, at 50%. It would be odd if gambling enthusiasts didn’t try to apply the Martingale method under these conditions. The essence of the trading system is as follows:
- The direction of market entry is chosen arbitrarily.
- The trader calculates the position size based on the account status and the minimum trade volume.
- Market entry is executed.
- The risk-to-reward ratio is set at 1:1. Stop orders (stop-loss and take-profit) are placed based on this ratio.
- If the stop-loss is triggered, the position size is doubled, and the cycle repeats. This continues until the next trade is closed with a profit (via the take-profit).
It seems quite attractive – even after a series of unsuccessful trades, the trader eventually makes a profit.
However, before drawing conclusions, a step-by-step algorithm needs to be considered in detail. Suppose a trader tries to make a profit on stocks priced at $10 each. They buy 10 shares for $100 and aim to make a $10 profit. Accordingly, they set the take-profit at $11 and the stop-loss at $9.
The market falls, the stop order is triggered, and the trader loses $10. Now they need to buy 20 shares, which will cost them $180. To compensate for the $10 loss from the previous trade and achieve the planned system profit of $10, they need to set the take-profit at $10 and the stop-loss at $8.
The next volume would be 40 shares at $8 each, totaling $320. They can achieve a $10 profit across all trades by placing the take-profit at $9, and so on.
There is another variant of using such a system. In this version, the trader does not set the stop-loss at the level where it should be placed but instead buys more of the asset in a volume equal to the already open position. For instance, using the previous example, after the price drops from $10 to $9, they buy another 10 shares. As a result, the average purchase price for the total position becomes $9.5 per share. They now need to move the take-profit to $10.5 and the limit order for the next 20 shares to $8.5. This variant looks somewhat better – the drawdown remains floating (not fixed on the balance), significantly reducing the account size requirements. This algorithm, with the placement of a grid of orders, is referred to in the trading community as a grid system.
Why Martingale Doesn’t Work in Financial Markets
Examining the classic variant of the system reveals two main drawbacks:
- For achieving a single profit (e.g., $10 in the example), the trader has to constantly increase the position size (up to $180 for the second trade, $320 for the third, and so on). This means the method can only work if there are sufficient funds in the brokerage account. It is also easy to notice the decreasing profitability – if it was 10% for the first trade, it becomes 5.55% for the second, and 3.12% for the third. Profitability continues to decline further.
- At the same time, the account drawdown increases – after the first unsuccessful trade, it is $10, for the second – $30, for the third already $70. One can calculate that in a series of 10 unsuccessful trades, a trader, trying to earn $10, will lose more than $10,000.
Although using a grid algorithm keeps the drawdown virtual, it does not make it smaller. The reduction of the account balance or equity (the amount of free funds) and the constant increase in positions, regardless of the variant used (classic or grid), requires a significant account size.
The example discussed illustrates the problems of the Martingale method in spot trading (without margin trades). Using leverage in the stock market or Forex worsens the situation even more. At first glance, it seems easier to succeed in margin trading – a proportionally smaller amount of funds is required (by the amount of available leverage). However, it is unlikely that a trader would aim for a profit of just $10 when the potential profit could be $100 with 1:10 leverage. At the same time, losses would increase proportionally, and their size in margin trading is limited only by the deposit size.
The method also does not work in futures trading. During clearing sessions on the exchange, settlement, accrual, and deduction of variation margin occur, which is essentially equivalent to fixing profit and loss on the open trade. Considering margin trading, the probability that the money in the account will run out before a successful trade closure significantly increases.
The situation is even worse with binary options, popular among many retail traders. Here, there are no equal outcomes – in case of success, the trader receives 60% to 85% of the option’s value, while in case of failure, they lose 100%. Thus, to meet the conditions of the Martingale method, the trade volumes have to be increased multiple times (e.g., tripling the position instead of doubling). The result is clear: the funds in the account run out even faster.
Some traders may argue that a long series of losing trades (4-5 or more) is unlikely. However, such a probability exists, and it is quite significant. For example, if the first trade is a buy near a local market high, followed by a bear market (as demonstrated by the crypto market in 2022), a series of dozens of losing trades can be expected in a downtrend (especially when using a grid algorithm).
The situation can be improved by opening trades based on trading system signals (each subsequent trade is made after receiving a signal). But if the system generates reliable signals, a reasonable question arises: is it worth increasing the risks using the Martingale method?
Many trading advisors developed by private traders for Forex use the grid variant of the Martingale method. None of them have shown stable performance – all of them eventually wipe out the deposit to zero.