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The Correct Application of the Martingale Strategy
  • The Correct Application of the Martingale Strategy

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    Before I go on with today’s article, I need to emphasize here that the views expressed in this article are mine and may or may not work for everyone. If you are a beginner, then this is certainly not for you. But if you have some experience, an open mind and are willing to try out new things all the time and challenge some long-held views about certain issues or topics in the forex market, then you may want to try this out…first on demo and then if successfully tested, on a live account with all the risk management that you should apply. With this out of the way, we can now progress to the crux of today’s piece.

    The Martingale trade strategy has received so many bad raps and hard knocks from many quarters that it is almost becoming suicidal to even advocate for this strategy in any way. Part of the reason why this is so is because the Martingale strategies are closely associated with the betting and gambling industry. We are told that in betting, the house always wins and everyday people flock to the slot machines in Macau and Vegas hoping to strike one big payday, constantly increasing the size of their bets to cover losses and with the hope of going home loaded with cash. As we all know by now, this never materializes for a lot of people and in the forex market, we tend to see some of this behaviour as well. However, this is a very irresponsible way of playing the markets. With the casinos, we know that everything is all about chance but with the forex market, a little bit of commonsense can make the difference. This is why I have come out plainly to discuss the Martingale strategy by putting forward some sort of advocacy for this strategy, showing how responsible and rational use of this strategy can actually work for the trader as opposed to working against the trader.

    What is the Martingale strategy?

    The Martingale strategy as we have just described, has its roots deeply set in the betting industry. It was first described by Pierre Levy in the 18th century, and can be defined as a trading technique in which the trader increases the size of an existing position when the market is moving against that position in order to recoup losses and profit faster. The underlying principle of the martingale is that the trade will eventually recover in the direction of the trader’s position, and so subsequent additions to the position will end up covering any losses sustained by the earlier position(s), reduce the cost of the trader by evening out the entry prices and spreads, and also cause a greater profit to be made than would have been originally achieved with the first positions.

    With the definition out of the way, we go on to illustrate the Martingale strategy in its simplest form. In this example, the trader starts with forex trading capital of $10,000, and aims to make some money from trades in which the risk is half the profit sought for each trade.

    What is the Martingale strategy?

    The Martingale strategy as we have just described, has its roots deeply set in the betting industry. It was first described by Pierre Levy in the 18th century, and can be defined as a trading technique in which the trader increases the size of an existing position when the market is moving against that position in order to recoup losses and profit faster. The underlying principle of the martingale is that the trade will eventually recover in the direction of the trader’s position, and so subsequent additions to the position will end up covering any losses sustained by the earlier position(s), reduce the cost of the trader by evening out the entry prices and spreads, and also cause a greater profit to be made than would have been originally achieved with the first positions.
    With the definition out of the way, we go on to illustrate the Martingale strategy in its simplest form. In this example, the trader starts with forex trading capital of $10,000, and aims to make some money from trades in which the risk is half the profit sought for each trade.

    He places four trades as follows:
    - The first position is started with a lot size of 0.5 lots with a 100 pip stop. The trade is caught out by the news and spikes against the trader by almost 50 pips. He is now down $250.
    - Undeterred, he decides to double up on the trade by taking on 1 standard lot on the existing position, hoping to cover losses quickly as he is confident the trade will recover. The position declines further by 30 pips. The first position is now down an extra $150, or $400 in all. The second position is down $300. The total unrealized loss is $700.
    - Determined to pull something out of the trade, the trader takes on an additional standard lot. He now has a trade size of 2.5 lots in the market, way above conventional risk exposure. Luck smiles on him as the position gains 15 pips. The first position is now down to -$325 and the second position is down to -$150.
    - He is probably on a winning streak now, so why not up the ante a little and add another 1.2 lots to the position? He does just that, and the market goes further in his direction by another 20 pips, only for the position to completely reverse and end up at the 100 pips stop loss position set for the first trade. With such a colossal loss, our trader’s account is in such a precarious state that he can no longer place trades with such jumbo sized volumes…
    This is the common story with Martingale strategies in the forex market, and the only reason why this is so is because traders are simply too careless with the use of the strategy. For instance, in our example above, what logical parameters did the trader use to implement any of the three subsequent entries? Absolutely none, and that is why we can see that the gambling mentality kicked in and he ended up the way most gamblers end up on the slot machines: with nothing.

    Now consider another example of Trader Jane who has a $5000 account and enters her first trade with a lot size of 0.1 lots. The first trade gains $50, but the second trade worth $20,000 (0.2 lots) which is a long trade is down by 80 pips and teetering close to the 100 pip stop she set for her trade. She hesitates however, and studies the market only to see that her earlier trade was made a little too much above the closest support. With price action now bouncing off the support, she adds to the position by using 0.5 lots, confident that this time, the trade will do well. She is rewarded for her industry, and the market moves up by 50 pips. She closes both trades, the first for a 30 pip loss ($2 per pip X -30 pips = -$60) and the second for a 50 pip profit ($5 per pip X 50 pips = $250). Her gain is about $190, being the difference between the profit from the second trade and the loss from the first trade.

    In this second example, we can see that Jane used the Martingale strategy, but with a difference. She studied the charts, understood that the reason her first trade did not do well was because she went long on the currency pair while it was still some distance away from the nearest support. She now waited until the price tested that support eventually without breaking it, and confident that the support would hold, she went ahead to double up on her initial trade size. This time, she did not even have to wait for the price to go back to the initial entry point before she cashed in on the trades, making a net profit in return.

    This is in a nutshell what Martingale trading is all about. However, the proper use of the Martingale strategy entails much more than this, and I am about to show you what I think should be the only circumstance in which the Martingale strategy should be used in the forex market. There are also conditions attached to the use of the Martingale strategy, and these are the conditions that must be met:
    a) The trading account must be well funded for the strategy to be successful.
    b) The trader must be trading only one currency pair so that maximum focus is attained.
    c) The trade size is very important. If you want to use the Martingale, ensure that the initial trade size is not more than 1% risk to the account. This is very important so that the subsequent double up move which uses a greater trade volume as part of the Martingale strategy does not push the risk to the account beyond the 5% maximum.
    d) It is not advisable to add to the initial position size more than once. Adding to the position more than once introduces a complex situation where the trades are more difficult to monitor.
    e) If at the time of adding to the initial position no basis is found for performing the Martingale, the initial trade should be managed either by carefully and sequentially closing out the position as the price action of the market swings and sways in an advancement and retracement, or the trade should be allowed to quietly end in a stop loss.
    Now that we have identified the conditions under which the Martingale should be used, let us now look at a practical application of this strategy.
    Martingale Strategy in Forex
    One of the reasons why a Martingale strategy has a chance to work when used in the forex market is that the value of a currency never gets all the way down to zero. A currency never becomes totally worthless, and it is only in very rare cases that the value of a currency can almost become worthless, but because there is a central bank in nearly every country, there are ways such events can be mitigated. In comparison, it is very possible for a stock that was worth hundreds of dollars to become nearly worthless. Bear Sterns was one such stock that went from being the toast of the market to nothingness.

    With such a fighting chance, it is therefore important that traders know the advantages of using the Martingale and use the strategy correctly. Usually, the cost of trade entry is reduced when the trader uses a Martingale-style entry for the trades. By adding to a position, the number of pips that will be required to produce breakeven is actually reduced. We need to think of this in statistical terms to understand how to play the Martingale.

    The usual call for Martingales is to keep adding to the existing position even as the market is going against the trader. But this conventional way of trading the Martingale does not factor in when the market will actually stop to retrace in the trader’s direction. Think of a bull or bear candle occurrence in terms of a heads or tails coin flip. For instance, what is the probability that a coin flipped three times will end up as heads all the time, or what is the probability that a bull candle will appear on the charts three times? A head-tail combo is a 50:50 situation, but when it comes to number of times that each side will appear, the probability actually reduces. It is now a function of how many times the 50% chance for a bull candle or bear candle (or we can say heads or tails of a coin) will hold true. So it is now a function of the 50% occurring 3 times in a row, which is 12.5% (0.5 X 0.5 X 0.5).

    However, what would be the chance of a tail appearing after two or three successive head flips, or what would be the chance of a bearish candle appearing after two or three bullish candles? That statistical chance now improves dramatically because the chance of a third bullish candle appearing after two bullish candles is only 12.5%, whereas the chance of a bearish candle appearing after three bullish candle (or a bullish candle appearing after three bearish candles) now becomes 87.5%.

    So it is not really a question of if the market has a high probability of turning downwards or heading upwards after an up move or down move respectively, but it is a question of the probability of the market retracing in the opposite direction after it has moved in a certain direction for some time. So if there is a 50% chance of a bullish candle following a bear candle, or a bearish candle following a bullish one, there is an 87.5% chance that a bear candle will follow three bullish candles, or a bullish candle following three bearish ones. This is the missing piece of the puzzle when traders attempt to use the Martingale strategy.

    Going forward with this, Martingale trades should therefore not be entered into when the candlestick that displays current price action is still in motion. Rather, it is more pertinent to wait to see if it will close at an area of support or resistance, or whether it will move with momentum to close beyond these areas, in which case, a breakout would have occurred thus opening the door for further movement in that direction. Support and resistance can be defined by several tools, but for our own purpose, we will use simple trend lines to define this.

    Martingale Strategy in Action

    In my own method of trading the Martingale strategy, I would want to use a situation where the price action of the currency pair has experienced a breakout by closing either above a resistance or below a support. If you look at my article on how to trade the breakout, you will see that I advocate that the market should be allowed to retest the key level that has just been broken. For a broken support, the market would therefore be allowed to head back upwards to retest the support now turned resistance, where it would usually be rejected for price to continue all the way down. For a broken resistance, we are looking for the market to attempt to test the resistance now turned support, and we expect the market to bounce off this trend line and start heading upwards without inhibition.

    But there is a problem. Trading long off a retracement bounce on a broken resistance, or going short of a retest and rejection off a broken support requires that the distance between the closing price of the breakout candle and that of the broken key level should not be too much. Perhaps 20 to 50 pips would do. But what if the trader is trading off a long term chart where such a distance may be up to 300 pips, or what if the momentum of the breakout candle is so much that even on a short term time chart such as the hourly chart, the gap between both coordinates is as high as 100 pips?

    What I have noticed is that because many traders are impatient and would not want to be seen to be leaving pips on the table waiting for a market retest, they immediately jump into the trade, leaving themselves exposed to a drawdown if the market does indeed attempt to test the broken levels. Imagine having a drawdown of close to 300 pips on a daily chart or 100 pips on an hourly chart, probably on an account that is not more than $1,000. How many traders can withstand such a shock? That is why one of the rules that must be obeyed before attempting a Martingale entry is that the account must be well funded or at least, be capable of taking micro-sized trades where the account is not more than $1,000.

    Another rule is that the initial entry made at the open of the next candle following a massive breakout candle must be done with a very small position size. The reason is this. It may make sense to try to dare the market by experiencing a drawdown and eventual recovery, but this is a risky strategy that has the tendency to overexpose the trading capital. Furthermore, using a small amount for the initial trade gives the trader more room to double up on the trade volume when adding to the position as part of the Martingale strategy.

    So in a nutshell, this is what the trader should do:
    a) If a large gap exists between the closing price of the breakout candle and the broken key level of support or resistance, use a very small trade size equivalent to 0.5% to 1% risk to enter the initial trade.
    b) If the market does indeed start to track back to the broken key level, do not be in a hurry to add to the position. Wait for the key level to be tested. Once the candle tests a broken resistance and does not close below it, or if the candle tests the broken support and does not go above it, then the key level is secure and it is most likely that the market will start to move again in your preferred direction.
    c) Understand that the market may test that key level several times before making up its mind.
    d) Do not use a pending order to setup the trader so that the position is not triggered prematurely. Rather use a market order only when the candle has tested the key level without being able to go below the resistance now turned support, or going above the support now turned resistance.
    e) Always wait for candles to complete before making the move.
    We reproduce a Martingale entry we have discussed initially to see how this works out.

    Look at Trader Jane’s Martingale entry to see how this is used.
    Another variation of the Martingale is to use the statistical formula we have used in the discussion above to your advantage. This will entail allowing at least three candles to form in the same direction that negates your initial entry. You then wait for the third candle to complete, before entering the opposing direction (i.e. the initial trade direction of your position). This is especially true if the new candle is allowed to complete and actually forms a candlestick pattern with the previous candle that favours an opposing move.

    Conclusion

    The trader must have the mental and physical stamina to see these types of trades out. In addition, the trader must be on the lookout for a situation where there is a fundamental influence that will cause a previously broken key level to be re-broken by an attempted retest of that key level. This situation happens all the time so vigilance is the watchword. A central bank could wake the markets up in the morning with a surprise just like the Fed Reserve did on January 22, 2008. If you find yourself in a situation where instead of a retest and bounce occurring, the key level is broken once more against your position, please walk away from the trade.

    Attention!
    The author’s views are entirely his or her own.

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