Martingale strategy and averaging down: What you need to know
Nothing creates a split camp more in trading circles than the Martingale system. One side will say it is amongst the oldest and simplest ways to ensure a profit; the other will mutter darkly about it being one of the most expensive ways to learn a lesson.
What is martingale strategy?
Developed in France in the 18th Century, the Martingale system works on a 50/50 premise. The idea is that if you keep doubling your bet after each loss, eventually you’ll earn back your money.
The system was introduced by the French mathematician Paul Pierre Levy. Much further 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, they must double their next bet to £20 on red. Lose again and double it once more to £40, and so on. When they do turn profit, in theory they would recover all their losses and gain on the initial position.
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 he won. He added, though, that “bad luck” meant he soon “left without a sequin”.
Martingale in trading
In financial markets, the Martingale trading strategy is implemented when a trader keeps doubling his position size till they make a profitable trade.
There are variations on this, where the trader increases their position each time they lose, but not necessarily by doubling it. Instead, our trader increases their position by a smaller amount, adding, say, 30% or 50%, rather than 100%. This is sometimes called ‘smooth Martingale’.
The Martingale technique, however, has many 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, and contains a high risk of loss.
For this simple reason most professional traders will avoid the method as the majority of people have to work within the boundaries of a limited bank balance.
In addition, as markets are affected by 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 through brokerage and overnight fees, and in certain markets there are taxes on each transaction, too. All assets will not get the best offer rates so bids will need to be increased. Similarly, you may not be able to sell all your assets at the best bid rate and have to decrease your offer.
Gamblers’ fallacy and other behavioural bias at play
Some experts claim that Martingale as a strategy leans into gamblers’ fallacy and that they must keep on gambling until their luck improves.
It is based on the belief that the chance of something happening with a fixed probability becomes higher or lower as the process is repeated. This is a misconception. More often than not, previous experiences have no bearing on future outcomes.
Investors can fall prey to gamblers' fallacy in two ways. The first will be to hold on to an asset that is falling in the belief that it can’t keep falling. The second risk is selling too early, as it seems unlikely that the asset price 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 they stand 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.
"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 keep investing more, believing the more you put in, the more it will pay off,” he said.
The principle behind it is that the same people who avoid loss are more likely to irrationally double down on risk.
Averaging down trading strategy
Traders have three options when a stock starts to fall. They can:
sell and take a loss
hold and hope
average down (double down)
With an averaging down strategy, the idea is that you invest more money after bad in the hope that the stock will perform well.
The Martingale-strategy averaging down can be implemented through a series of closed positions that have gone against you, or by doubling down 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. According to trader and strategist Steve Connell, Martingale, in a “nutshell”, is a cost-averaging strategy
Yet, what is averaging down in stocks? It is a widespread practice of buying more – or averaging down – stocks that you have already invested in as the price falls.
This then lowers your average price and that makes it easier to break even or 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 only compounds the problem, as it can only work if the stock price rises again.
The key is to hold on to the stock for as long as it takes to recover, but If it keeps falling it could be a fast route to bankruptcy.
If you practice short selling, the same risks and same logic appear if you average up and invest money in a position if the price goes up when you hoped it would go down. Again, you can do this for a series of closed trades or within an open trade with an unrealised loss.
The reverse Martingale
A more logical method for traders is to use an anti-Martingale system. This is something that is seen by many to be a more effective way to maximise opportunities.
The strategy requires discipline, as psychologically it can be harder to increase risk when you are already in profit.
With the reverse-Martingale, averaging up rather than down means that profits can quickly turn into losses should the market turn against you.
Traders who average up can limit the average price that they pay for stocks by making smaller and smaller purchases as the price gets higher. This is known as pyramiding and was something that Warren Buffet did with Berkshire Hathaway.
Martingale strategy in forex and option trading
Some traders claim that a ‘smarter’ version of the Martingale system could be used when trading binary options. To do this a maximum limit should be set and traders need to keep in mind that even when winning you could also lose at a certain point. It is also important that you trade only money that you can afford to lose.
Another benefit is that you don’t need to predict the market direction to use it, as it has a well-defined set of trading rules.
Martingale trading systems are also popular in forex automated trading, because, unlike stocks, currencies rarely drop to zero.
The forex carry trade is a type of strategy in which traders sell currencies of countries with relatively low interest rates, and use the proceeds to buy currencies of countries that yield higher interest rates.
A note of caution is that these currency pairs with carry opportunities often follow strong trends so can fall victim to unexpected changes in the interest rate cycle.
Experts go to lengths to point out that you need to be disciplined enough to bank your gains so that they don't snowball for too long. There are also tools traders can use to control the martingale strategy trading such as the stop-loss and take-profit orders.
“The major problem for martingale systems is that every next result is completely independent of the previous results, so the streak of any number of losses is totally possible. In forex the probabilities are not linear, so the streaks can have some inner logic dependent on markets,” said trader Andriy Moraru.
Common errors
This ‘double up to catch up’ method is one of the common errors made by losing traders. There is a school of thought that if you are averaging down it’s because a mistake was already made in stock selection and buying more stock is throwing good money after bad.
It might, therefore, make more sense to move on and invest in something else. Yet, psychologists say it is an instinctive reaction to take on a greater risk if you are on a losing streak, believing that eventually you will strike gold.
Robert Williams, clinical psychologist and Addictions Counselling professor at the University of Lethbridge in Alberta, calls it the "near miss" effect. He says it is like when people play the lottery and get half the numbers right and think they were "so close" so promptly re-enter.
This is why before averaging down on any trade it is important to have a plan, rather than throwing money ad hoc into a company with a falling share price and getting carried away.
Carry out due diligence on the assets you wish to average down on so that quick action can be taken if needed to cap a loss. You can use a stop-loss and a guaranteed stop-loss as part of your risk management strategy. Some analysts say that you should average down only when nothing about a company has changed except its share price.
Before adding to a losing position, investors should ask themselves: do I have in my initial research or do I just need to acknowledge that I made a mistake and switch to the next opportunity?
Traders need to plan and adapt endlessly. Thinking ahead is the key to this, as is treating every trade individually.
Averaging down using a Martingale strategy requires patience, confidence and the knowledge that markets do not always move in your favour. The same as in roulette – just because the ball landed on red the previous ten times, it doesn’t mean that the next number will be black.
Martingale, in all its forms, comes with a warning. Be careful. Traders apply this approach inside predefined systems. But even if you are an experienced trader, make sure you have a good risk management strategy in place. Martingale strategy and averaging down could be an easy way to lose a lot, fast.
FAQs
Is Martingale strategy effective?
The Martingale technique in trading has many practical drawbacks. As it has a statistically computable outcome, the Martingale system can, under certain conditions, create incremental profit, yet the risk of loss is very high. The principle can only work if the pattern remains uninterrupted. In reality, this requires an extremely large, if not infinite, bankroll. For this simple reason, most traders would 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 affected by external factors.
Is Martingale strategy safe?
The Martingale strategy may not be safe in trading, as markets are affected by various external factors, and the strategy presupposes a statistically computable outcome. The principle behind the strategy is that 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 traders would avoid the method, as the majority of people have to work within the boundary of their limited bank balance.
Is it worth averaging down on a stock?
Averaging down is a widespread practice of buying more stocks in companies you have already invested in as their 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. You should always conduct your own due diligence before investing or trading. And never trade money you cannot afford to lose.
