The Martingale approach and averaging down

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.

The Martingale system works on a fifty/fifty premise such as blackjack, or a heads or tails format. Source: Shutterstock

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.

Averaging down

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.

Connell said: “The idea is that you just go on doubling your trade size until eventually fate throws you up one single winning trade. At that point, due to the doubling effect, you can exit with a profit. The act of ‘averaging down’ means you double your trade size. But you also reduce the relative amount required to re-coup the losses.”

They key is to hold on to the stock for as long as it takes to recover, but If it keeps on falling it could be the fast route to bankruptcy.

Connell added: “Averaging down is a strategy of avoiding losses rather than seeking profits. Martingale doesn’t increase your odds of winning. It just delays losses – for a long time if you’re lucky.”

If you practice short selling, the same risks and same logic appear if you average up and throw more money into 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 traded with an unrealised loss.

The reverse Martingale

A more logical method for traders, especially Forex 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 as it hangs on to winning trades, and drops losers.

As a strategy it requires discipline as psychologically it can be harder to add on risk when you are already in profit.

However with the reverse-Martingale, the averaging up rather than down means your profits can be turned very quickly into loses should the market turn against you.

Investors 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.

When could the Martingale system be profitable?

Some more experienced 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 you are winning you could also lose at a certain point. It is also important to only to go ahead only when you have something 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. Although companies easily can go bankrupt, countries cannot.

Martingale trading systems are also popular in Forex automated trading. Shutterstock.com

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 be victims of unexpected changes in the interest rate cycle.

Experts also 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. In Forex there are flexible tools to control martingale trading such as the ‘stop-loss and take-profit’ orders.

Forex trader Andriy Moraru, said: “The major problem for martingale systems in gambling 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.

“It makes martingale trading system less predictable and potentially profitable if optimised to the market conditions. But well optimised and modified martingale systems, in my opinion, can’t be called martingale and can’t be discussed as the one.”

Common errors made by losing traders

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 is 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, a professor of health sciences and gambling studies 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. “So while they might believe that they just missed the target, the difference in probability is actually in the hundreds of millions.”

When people play the lottery and get half the numbers right and think they were "so close" so promptly re-enter. Source: Shutterstock

This is why it is advisable before averaging down on any investment that the investor has 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 companies you wish to average down on so that quick action can be taken if needed to cap a loss. Some analysts even 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 this question: how much faith do I have in my initial research or do I just need to acknowledge I made a mistake and switch to the next opportunity?

Professional traders need to plan and adapt endlessly. Thinking ahead is the key to this as is treating every trade individually.

Doubling down using a Martingale strategy requires patience, confidence in the stock and 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, doesn’t mean that the next one will be black.

Martingale, in all its forms, comes with a warning. Be careful. Professionals apply this approach inside predefined trading systems. But even if you are an experienced trader,  make sure you have good risk management strategy in place. Martingale is an easy way to lose a lot, fast.