Martingale strategy: what it is and how to trade with it

The Martingale strategy is one of the most controversial Forex trading strategies known to traders. Learn the history behind this gamble-like technique and how to use it wisely and effectively.

The history of the financial market is littered with multiple traders who have used different strategies to make money. In the 30s, Jesse Livermore used a simple price action strategy to make a fortune. In the 50s, Warren Buffett started his investment company with a long-term view. Today, the company has a market capitalisation of $516 billion. In the 80s, James Simmons introduced the concept of algorithmic trading. As of today, his net worth exceeds $18 billion. At the same time, Steve Cohen built a fortune of more than $11 billion by insider trading, while Carl Icahn built a fortune of more than $16 billion by being a corporate trader.

These examples show how diverse the capital market is and how people have used different methods to make money. Thousands of other strategies are used every day by traders from around the world. Some methods, like value investing and price action trading, have been widely accepted. Others, like the Martingale trading strategy, are more controversial.

What is the Martingale strategy?

Martingale is an old strategy developed by French mathematician Paul Pierre Levy. Paul was a famous French mathematician who laid the foundation for several probability theories, such as local time, stable distributions, and characteristic functions.

The concept of his Martingale strategy was originally used in the gambling industry. To this day, many casinos have applied his ideas to introduce betting minimums and maximums. It has also been applied in the design of the roulette wheels, which have two green markers in addition to the odd or even bets.

The strategy is based on the mean reversion ideology. According to this theory, traders double down on a losing bet. For example, if you place a bet worth $10 and lose, the strategy recommends placing another bigger bet. If this one fails, you initiate another bigger one. With mean reversion, the approach assumes that the losing streak will reverse at a certain point and that the more significant win will cover the losses.

Types of Martingales

Let's explore different Martingale approaches and what sets each one apart.

Grand Martingale

In this method, if traders lose a trade, they double the amount they invested and add an extra unit to their next trade.

In Forex trading, if a trader is using a standard lot in trading (1 lot), if they open a trade and the trade hits the predetermined stop loss, the trader will double the lot size and add a small unit, such as 0.01. Thus, the second lot will be a 2.01 lot size. If the trade does not profit, the trader will double the previous lot and add a small unit, i.e. 2.01×2(+0.01) = 4.03 lots.

The Grand Forex Martingale aims to eventually recoup all previous losses and make a small profit. However, it can be risky if not managed carefully.

Reverse Martingale

In contrast, this strategy caters to market participants who prefer not to chase losses but rather capitalise on winning streaks. In this strategy, traders double their position after each win and revert to their initial investment amount following any loss.

The Reverse Martingale strategy necessitates a careful analysis of market trends—both technical and fundamental—to gauge the potential duration of winning trades without hitting a predetermined limit. The primary focus here is on preserving gains while minimising losses. A single loss can negate all prior profits, hence the strategy's emphasis on risk management and disciplined trading practices.

Pyramid Martingale

This Martingale Forex approach represents a trend-based variation of the initial strategy. It aims to grow the trader's account by aligning trades with prevailing market trends. After each win, the trader resets their trade size while still striving to secure at least one unit of profit per successful trade.

This method encourages a decrease in the trading size after each win. It reflects the belief that every win should be treated as an opportunity for incremental growth rather than an invitation to chase previous losses, making it appealing to traders who prefer to avoid significant investments and seek a more conservative approach to trading.

Martingale strategy examples

The following examples demonstrate how the Martingale strategy can be effectively used in Forex trading. By increasing your investment during downturns, you facilitate potential recovery and profit when the market rebounds.

Let's consider a scenario of trading the USDEUR currency pair, currently valued at an exchange rate of 1. You initially purchase one unit of this currency pair. If the exchange rate subsequently falls to 0.70, you incur a loss of 0.30. Rather than exiting the trade, you buy two additional units at a total cost of 1.40, resulting in a cumulative investment of 2.10 for three units. This adjustment lowers your average cost per unit to 0.70. If the market then rises to an exchange rate of 1.10 and you sell all three units for 3.30, your overall profit from this trading activity amounts to $1.20.

Consider a situation where you are trading the GBPJPY currency pair, currently valued at an exchange rate of 150. You begin by purchasing one unit of this currency pair. If the exchange rate falls to 140, you experience a loss of 10. Instead of closing your position, you buy two additional units at a total cost of 280, bringing your total investment to 290 for three units. This adjustment lowers your average cost per unit to approximately 96.67. If the market subsequently rises to an exchange rate of 160 and you decide to sell all three units for 480, your overall profit from this trading activity will be $190.

How does Martingale work in trading?

Financial securities are either bullish or bearish. During these trends, the market creates patterns, which include pullbacks. When traders initiate a trade, their aim is to benefit from a trend. When they open a buy trade, their aim is to benefit from an upward trend, and when they sell, their aim is to benefit from the declining price. The most profitable trades are those that are in line with the trend.

Since the market involves risks, these trends take time to identify, which is why even the best traders in the world make occasional losses. When this happens for traders using the Martingale approach, they double down on the trade.

If the original trade were to buy 0.01 lots of the EURUSD, the trader would then buy 0.02 lots. If the second trade makes a loss, the trader will buy another lot of 0.04, and if that trade loses, they double down by buying 0.08 lots. The assumption is that if the final trade makes a profit, it will cover the previous losses. Therefore, the size of the lot and the price of the security become better for the trade.

The approach is also based on the cost-averaging method. In this method, traders double down on the trades when their price moves against them. For example, assume that you have bought the stock of Daisy, LLC at $50. After a few days, an investment bank releases a report downgrading the stock, which causes the stock to fall to $40. You can decide to exit the investment with a $10 loss. However, you can continue buying the stock if you believe in the company. If the stock recovers, you will make a more significant profit.

A good example is when Bill Ackman—a prominent hedge fund manager—bought the restaurant chain's stock, Chipotle Mexican Grill, at $410 in 2016. A few months after purchasing, the stock rose to $500 before falling. It reached a low of $250 in early 2018. During this time, his fund bought more shares. The stock started moving up in the first quarter of the year, and by August, it was trading at $520. As a result, the investments he made at $250 were more profitable than the initial investment.

How to trade with Martingales

To effectively employ the Martingale strategy in Forex trading, follow the structured approach consisting of several key steps.

1. Select a suitable currency pair based on current market conditions. Determining whether the market is trending (showing an apparent upward or downward movement) or non-trending (oscillating within a range) is essential. It is crucial to do a thorough analysis of the historical performance of the chosen currency pair. Ideally, this pair should demonstrate a tendency to yield more profit opportunities than losses over time.
2. Open the first position. In a bullish market, traders typically initiate buy positions with rising prices. Conversely, traders initiate sell positions in a bearish market where prices fall. This initial order sets the foundation for subsequent trades.
3. Monitor the market. If the value of the selected currency pair decreases after the initial trade, double your position size for the next trade. This process can be repeated multiple times, adhering to any predetermined maximum trading limits, until the price of the currency pair rises again.
4. Exit the position to secure gains when the exchange rate of the currency pair increases, thereby covering all previous losses and achieving a net profit.

Risks in trading with the Martingale strategy

The Martingale approach to trading comes with a few risks and should be used carefully.

• The currency pair might continue with one trend for a long time. A good example is what happened in the gold market in 2018. In April, the price of gold reached a high of $1,365. It then started falling and reached a low of $1,160 in August. Therefore, traders who were bullish on gold and continued to double down made significant losses because the trend did not reverse.
• Another example is with Bill Ackman again. A few years ago, he invested in Valeant Pharmaceuticals when the stock was at $150. After a few months, the stock rose to $250 and started falling. As it declined, he bought more, hoping the stock would recover. In 2017, he was forced to exit the investment with a $4.4 billion loss.
• The compounding losses would require unlimited capital to trade this system.
• It is subject to heavy losses if the market is range-bound.

Does this strategy work for you?

The Martingale trading strategy is quite controversial among traders. When used well, it can help you recover losses and trade effectively. However, when things go wrong, the losses can add up. Therefore, it is recommended that you take time to learn and practise it using a demo account, ensure you have a healthy account balance, and have your risk management strategies in place.