Martingale Trading Strategy (Backtest And Example)

Last Updated on October 10, 2022 by Oddmund Groette

There are different strategies for trading the market, such as trend following, price action, scalping, momentum, Martingale, mean-reversion, and so on. All are risky, but the Martingale strategy is known for its huge risks. What is this strategy and how does it work?

In financial trading, the Martingale trading strategy refers to the idea of adding a larger trade size to a losing trade with the hope that the market eventually reverses and it ends up in a net profit equal to the size of the initial bet. The idea was originally made for gambling, and it is based on the statistical outcomes of an event with a 50% probability of it occurring, such as winning a trade.

In this post, we take a look at the Martingale strategy. The strategy is not among the easiest to backtest with strict trading rules, but we make an example at the end of the article.

What is the Martingale trading strategy?

In financial trading, the Martingale trading strategy refers to the idea of adding a larger trade size to a losing trade with the hope that the market eventually reverses and it ends up in a net profit equal to the size of the initial bet. That is, if a $1 trade is losing, you make a fresh $2 trade in that direction and continue doubling each fresh position size until you win and recover the losses plus a profit worth the initial $1.

The idea was originally made for gambling, and it is based on the statistical outcomes of an event with a 50% probability of it occurring, such as a coin toss. For this type of situation with an equal probability, the Martingale strategy states that if you double the size given a loss, you regain whatever’s been lost plus a profit.

This technique is in contrast with the anti-Martingale system, which involves halving a bet each time there is a trade loss and doubling it each time there is a gain. Unlike the anti-Martingale, which seeks to reduce risk, the Martingale strategy is a risk-seeking method of investing that betrays an aversion to accepting losses.

The Martingale strategy is based on the theory of mean reversion, which opines that the price retraces towards its mean after some time. Since the market is likely to reverse at some point, it believes the trader should increase the amount invested as the price falls —in anticipation of a future increase. However, without an infinite supply of money to keep investing, the strategy won’t work. Moreover, the amount risked by continuing to invest is far higher than the potential gain.

The Martingale strategy is commonly used for betting in a casino to break even after a loss. After experiencing a loss, gamblers would double the size of the next bet and continue down that path until they eventually even out with a win or have no money to bet. If the gambler has an unlimited supply of money to bet with or at least enough money to make it to the winning payoff, the strategy works. If he runs out of cash, he loses everything — an addict might even bet with his house.

How the Martingale strategy works

Let’s look at a basic example to explain how the Martingale strategy works. Here, we use coin tossing and bet on either heads or tails. There is an equal probability that the coin will land on heads or tails, and each flip is independent — the preceding flip does not impact the outcome of the next flip.

The Martingale strategy states that as long as you stick with the same call, say heads, you would eventually get a win (see the coin land on heads) if you have an infinite amount of money to keep betting.

Now, let’s say you bet with a fixed sum of $100, and the bet was a loser (tails instead of heads). You would increase your bet size to $200. If it comes out tails again, which is another loss, you increase your trade to $400. You continue this process until you end up with a winner.

Here’s what the outcomes would look like:

  1. If you win the first bet, you win $100
  2. If you lose the first and win the second bet, you end with a net $100 profit ($200 – $100)
  3. If you lose the first two bets ($100 + $200 = $300) and win the third bet, you end up with a net profit of $100 ($400 – $300).
  4. If you lose the first three bets ($100 + $200 + $400 = $700) and win the fourth bet, you end up with a $100 net profit ($800 – $700).

You can see that, at any stage, the size of the winning bet will exceed the combined losses of all the previous trades, and the difference is the size of the initial bet.

Is the Martingale system the same as the double-down strategy?

The Martingale strategy may look very similar to the double-down strategy, and in fact, both are based on the same principle of mean reversion and expectation of a reversal. But technically, they are not the same. With the Martingale strategy, the trader adds a larger trade size (double the former position) after each loss. However, in the double-down strategy, the trader only adds the same position size as the initial losing position.

In other words, the Martingale strategy increases the risk size more than the double-down strategy does. But both strategies increase risk exposure and stem from a psychological state of loss aversion.

Who invented the Martingale strategy?

The idea behind the Martingale strategy started many hundred years ago when it was introduced by a French mathematician, Paul Pierre Levy, in the 18th century. The Martingale strategy is based on the principle of probability and establishes the premise that only one good bet is needed to turn your fortunes around.

The mathematician figured that there is a non-zero probability of getting the same outcome and that doubling the wager ensures that any winning bet offsets all the previous losses. He was later awarded a major award for his work in the mathematical field of probability.

Martingale strategy example

Let’s say a trader who uses the Martingale strategy buys $1,000 worth of a stock when it is trading at $50 per share. If the stock price falls in the following week and the trader buys $2,000 worth of the stock at $25, the average buying price falls to $30 per share.

Assuming the stock price decline more, falling to $12.50 per share, the trader buys $4,000 worth of the stock at that price. This takes down the average cost per share to $16.66. If the stock rises at this point to $19.05, the trader can successfully exit the trade and make a profit of $1,000 — which is equal to the initial amount invested.

This is just an example; it does not always happen that way. A stock can keep declining to zero if the company becomes insolvent.

Martingale strategy success rate (win rate)

The Martingale strategy has a high win rate. Generally, there may only be a few losers, but they are BIG. Theoretically, with an infinitely deep pocket, the strategy has a near 100% success rate, as all you need is one winner to get back all of your previous losses, so you must keep throwing in more money.

However, if the money supply is not adequate, a long enough losing streak could cause you to lose everything. You need an infinite supply of money to achieve 100% profitability — but it must be an asset like forex, which does not fall to zero. Another benefit of forex is that if the trade is in the direction of a positive carry (using a low-interest rate currency to buy a high-interest rate currency) the swap payment can reduce the losses while waiting to get a winning trade. So, it might work better when going long AUD/JPY currency pair because the AUD tends to have a higher interest rate than the JPY.

Is Martingale the same as averaging down?

They are closely related but not the same. Averaging down, also known as scaling in, is investing a specific amount when the price of an asset you planned to buy falls. The amount invested at each trade is a part of the money already planned to invest in the asset. In this case, averaging down the entry price is a planned method of entry.

The Martingale strategy, on the other hand, is adding more positions when the initial position is losing. It is a way of avoiding losses by unwisely seeking more risks.

Does Martingale work in the stock market?

The Martingale strategy was initially developed for betting on any game with an equal probability of a win or a loss. But people now brought it into the financial markets. The stock market is not a zero-sum game and not as simple as betting on a roulette table.

Therefore, the strategy may be dangerous to apply in the stock market. Since stocks can fall to zero, a trader can lose everything even if he has an infinite supply of money. Also, given that stocks theoretically have infinite potential to rise, it may be dangerous to apply for short selling.

However, the strategy may work (long only) with a broad market index ETF, such as the S&P 500 index ETF — SPDR S&P 500 ETF (SPY), iShares Core S&P 500 ETF (IVV), and Vanguard S&P 500 ETF (VOO). These are unlikely to fall to zero, and the US stock market tends to go up in the long run.

Martingale trading strategy backtest

Coming soon.

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