Any ambitious trader is always looking for a way to improve their strategy or system.
On the other hand, novice traders can be slightly one-dimensional in their focus.
More often than not, inexperienced traders are too concerned with entry signals...
…and this can be detrimental to other important areas.
These areas are:
It's easy to underestimate each of these aspects.
Entry signals tell you when it is a good time to trade.
Position sizing is a discipline about how to trade.
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Some theories on position sizing derive from games of chance - specifically from betting progression systems.
This article discusses Martingale trading, which is a position sizing strategy.
First, we will take a look at Martingale in its original context of a game of chance.
Then, we'll explore Forex Martingale trading.
The theory behind a Martingale strategy is pretty simple.
It is a negative progression system that involves increasing your position size following a loss.
Specifically, it is doubling up your trading size when you lose.
The classic scenario for a Martingale progression is trying to trade an outcome, where there is a 50% probability of it occurring.
Such a scenario has zero expectation.
You would expect to make nothing and lose nothing in the long run.
For this kind of 50/50 proposition, there's two schools of thought about how to size your trade size.
Martingale strategy is about doubling your trade size when you lose.
The theory is that when you do win, you regain what you have lost.
On the other hand, anti-Martingale strategy says you should increase your trade size when you win.
Let's look at an example of Martingale.
Consider a trade that has only two outcomes, with both having equal chance of occurring.
Let's call these outcome A and outcome B.
The trade is structured so that your risk reward is at 1:1 ratio.
You decide to trade a fixed sum of $5, hoping that outcome A will occur:
...but outcome B occurs instead...
...and your trade loses.
For the next trade, you increase your size to $10, once again hoping for outcome A.
It's B that occurs and you make a loss of $10.
Once again, you double up and now trade $20 - needing outcome A to gain a profit.
You keep doing this until eventually your required outcome occurs.
The size of the winning trade will exceed the combined losses of all the previous trades.
The size by which it exceeds them is equal to the size of the original trade size.
Let's run through some possible sequences.
The probability of you not profiting eventually is infinite - provided you have infinite funds to double up with.
As you can see from the sequences above:
...when you do win eventually…
...you profit by your original trade size.
It sounds good in theory.
The problem with this strategy is that you only stand to make a small profit.
At the same time, you risk much larger amounts in chasing that small profit.
In our example above, we are looking to make only $5.
But with a losing sequence of just three trades:
...we were already risking $40.
Imagine if that losing streak had persisted a little longer.
If you lose six times in a row, you are risking $320 to chase your $5 profit.
In other words, you are sitting on a loss of $315, attempting to win just $5.
The chances of getting a six-trade losing streak are small - but not so remote.
In fact, they are greater than 1%.
What if your risk capital was only $200 in total?
You would be forced to quit with a large loss on your hand.
This is a key problem with the Martingale strategy.
Your odds of winning only become guaranteed if you have enough funds to keep doubling up forever.
This is often not the case.
Everyone has a limit to their risk capital.
The longer you apply a Martingale trading strategy, the greater the chances that you will experience an extended losing streak.
Depending on your mindset, you might find this an off-putting proposition.
Needless to say, Martingale strategy does have its advocates.
Now, let's look at how we can apply its basic principle to the Forex market.
How does a Martingale strategy work in Forex trading?
The Forex market doesn't naturally align itself with a straightforward win or lose outcome with a fixed sum.
This is because the profit or loss of a Forex trade is a variable outcome.
We can define price levels at which we take-profit or cut our loss.
By doing so, we set our potential profit or loss as equal amounts.
The chart above shows a minute chart of EUR/USD with the Relative Strength Index (RSI) plotted beneath.
Don't forget - RSI is one of the many indicators available through MetaTrader 4 Supreme Edition.
It's there to give us a simple entry point and suggest the state of the market:
...if the RSI drops below 30, it suggests oversold...
...and if it rises above 70, it suggests overbought.
At 10:03 on the chart, the RSI rises above 70.
This is our entry point.
We sell one lot of EUR/USD at 1.1095.
We place a limit 30 pips below at 1.1065.
This is where we take out profit.
We place a mental stop 30 pips above at 1.1125.
Unfortunately, EUR/USD continues to rise and at 10:15, our stop is breached.
We define ourselves as having lost at this point.
The Martingale strategy now calls for us to double up.
We only use a mental stop-loss rather than an actual stop order.
Why do this?
Because it would be pointless to close out the trade and then reopen another trade twice as large.
Instead, we open a new trade matching the size of the original trade to double up.
We sell another lot at 1.1125.
We place a new mental stop 30 pips above at 1.1155.
We replace our original limit order with a new one to close both trades.
This is 30 pips below our new trade, at 1.1095.
We originally sold one lot at 1.1095 and then sold another at 1.1125.
This gives us an average entry point of 1.1110.
We're in luck this time and the market drifts down through our limit in the next few hours.
At 13:55, we close out at 1.1095.
We closed out 15 pips below our average entry point.
One lot of EUR/USD has a pip value of $10.
Therefore, we make 15 pips multiplied by $10/pip, which nets us $150.
That is a very simple example to give you an idea of how we might apply a Martingale strategy.
It worked out in profit in the example:
...but can you imagine a scenario where you might have a sequence of several losing trades in a row?
It is a distinct possibility.
Martingale's stick to your guns approach might work in situations with high probability of reversion to the mean.
But it is extremely risky in a trending market.
The strategy always has the risk of building up a large loss, that squeezes you out of the market.
A downside of Martingale trading strategy is that you are gambling with your losses:
...which is usually viewed as breaking the rules of good money management.
It's interesting to compare it with reverse Martingale or anti-Martingale strategy (a methodology often utilised by trend-following traders).
The latter involves:
The general results of Martingale are:
There is a limit to how long you can keep doubling up without running out of money.
And the strategy crumbles if you run into a string of losing trades.
Exponential increases are extremely powerful and result in huge numbers very quickly.
Therefore, doubling up may result in unmanageably large trading size.
In such a scenario, continuously increasing the trade size is unsustainable.
You will certainly be squeezed out of the market at a large loss.
If we had a group of traders using the strategy for a limited period, we would expect to find that:
So while the results of Martingale may sound satisfying, the strategy is too inconsistent to be used on a regular basis.
But it does provide value and is a great tool for getting more market insight.
If you want to experiment with the Martingale approach, the best way to start is in a risk-free environment.
Our demo trading account can help you find a Forex Martingale strategy that suits you best.