Nothing creates a split camp more in gambling circles than the Martingale system. One side will say it is amongst the oldest and simplest ways to ensure a profit, whilst the other will mutter darkly about it being one of the most expensive ways to learn a lesson.
Developed in France in the 18th Century, the Martingale system works on a fifty/fifty premise such as blackjack, or a heads or tails format. The idea is that if you keep doubling your bet after each loss then eventually you will win back all your money.
The Martingale was introduced by the French mathematician Paul Pierre Levy and much of the study in the area was carried out by American mathematician Joseph Leo Doob who sought to disprove the possibility of a 100% profitable betting strategy.
Most experts use the roulette table as an example for how the system works. If a gambler bets £10 on red and loses then he must double his bet to £20 on red. If he loses again he doubles it once more to £40 and so on. When he eventually wins he will not only return his losses, but will guarantee a win of the initial bet.
According to the memoirs of Venetian author and adventurer Giacomo Girolamo “Casanova” de Seingalt, this simple betting progression was in vogue at the original Ridotto Casino as early as 1754. Casanova wrote of doubling the size of his wager after every loss until his bet eventually won. He added, though, that “bad luck” meant he soon “left without a sequin.”
Martingale in stock market trading
In stock markets, the Martingale strategy is implemented when a trader keeps doubling his position size till he makes a winning trade.
There are variations on this, where the trader increases his position each time he loses but not necessarily by doubling it. Instead our trader increases his position by a smaller amount, adding say 30% or 50%, rather than 100%. This is sometimes called smooth Martingale.
The Martingale system, however, has many practical drawbacks in this environment.
As it has a statistically computable outcome, the Martingale system can under certain conditions create incremental profit. Yet, the principle of it can only work if the pattern remains uninterrupted. In reality this requires an extremely large, if not infinite, bankroll.
For this simple reason most professional traders will avoid the method as the majority of people have to work within the boundary of their limited bank balance.
In addition, as markets are affected by so many external factors, from national disasters to regulatory announcements, it is unlikely that the pattern can continue without being knocked sideways by a market curve ball.
The risk-reward ratio is another disadvantage. You can’t predict the number of successive losing trades that will take place, so the risk will keep increasing with each trade. Yet the possible reward is limited to the position size of the first trade.
There are also costs involved with every trade such as brokerage and in certain markets there are taxes on each transaction too. All shares will not get the best offer rates so bids will need to be increased. Similarly, you may not be able to sell all your shares at the best bid rate and you may have to decrease your offer.
Gamblers’ fallacy and other behavioural bias at play
Many experts claim that Martingale as a strategy leans into gamblers’ fallacy and the notion that to catch the anticipated good luck they must keep on gambling.
It is based on the belief that the chances of something happening with a fixed probability become higher or lower as the process is repeated, yet this is a misconception as, more often than not, previous outcomes have no bearing on future outcomes.
Investors can fall prey to gambler's fallacy in two ways. The first will be to hold on to stock that is falling in the belief that it can’t keep on falling. The second risk is liquidating too early as it seems unlikely that the stock can keep rising.
As psychologists Amos Tversky and Daniel Kahneman discovered, most of us like to avoid losses. Their research found that the average person is willing to risk a potential loss only if he or she stands to gain at least double that amount.
The sunk-cost fallacy
Another study by psychology professor Harold Miller from Brigham Young University found that behavioural-driven financial fallacies can go hand-in-hand. He found that people who demonstrate loss aversion are more likely to fall victim to the sunk-cost fallacy, and vice versa.
He said: "The sunk-cost fallacy is behaving as if more investment alters your odds. In a way, you are also motivated by an aversion to loss, but you keeping investing more, believing the more you put in, the more it will pay off."
The principle behind it is that the same people who avoid loss are more likely to double down on risk irrationally.
Investors have three options when stock starts to fall. They can:
- sell and take a loss
- hold and hope
- average down (double down)
With double down the idea is that you throw more money after bad in the hope that the stock will perform well.
This Martingale strategy can be implemented through a series of closed positions that have gone against you, or by averaging within an open position. In the first case there is a real loss and the next time the volume is doubled. In the second case, there is an unrealised loss and a volume is added to the open position.
This ‘doubling down’ is the key to the Martingale System and according to trader and strategist Steve Connell, Martingale in a “nut shell” is a cost-averaging strategy.
Averaging down is the widespread practice of buying more stock of something you have already invested as the price falls. This then lowers your average price and that makes it easier to break even or to turn a profit. However, it also makes it easier to lose more money as you’ve built a larger concentration of shares.
It can be a dangerous strategy as the asset has already shown weakness, rather than strength. Some feel adding more cash to the pot is only compounding the problem as it can only work if the stock price rises again.