Sounds simple enough, right? In theory, you could keep doubling down even for the next 25 flips and lose the first 24 flips the probability of that is low. But on the winning flip, you make more than enough money to cover your losses and net a profit. There are two primary schools of thought on how it came to be.
Many believe it originated in 17th or 18th century France, like most modern gambling traditions. At the time, gambling was the order of the day; the upper class gambled with more money than sense while the lower class gambled what they had to afford a life.
Because it was becoming so rampant, various scholars started looking at the science behind the probability of various games. Among these scholars, French mathematician Paul Pierre Levy is credited with making the martingale strategy a popular method for profitable betting. The second school of thought believes that the strategy was named after John Henry Martindale, a casino owner in London. John was said to encourage gamblers in his casino to wager by doubling down their stakes since the mathematics proved that they were guaranteed to earn their money back with a little profit on the side.
As if to prove his point and make the martingale even more popular, a famous gambler known as Charles De Ville Wells would go on to use the strategy to turn 4, francs into over 1,, francs in Monte Carlo. It introduced more possible outcomes than just black and red.
What if you hit an exceptionally long losing streak and you run out of cash before your first win? Remember that the size of the bet keeps growing to enormous proportions after the initial wagers. When that losing streak continues for too long, you might have to take your compound losses and make a hasty exit before you ever get the chance to recoup your losses.
If you really think about it, the risk-reward ratio is not that favorable either. Whether gambling at the casino or trading securities, nobody wants to lose. So while, in theory, the martingale strategy seems foolproof, the reality is that accelerating your losses in hopes of turning a meager profit equal to your initial bet size is not just impractical but downright hazardous.
Lastly, the strategy does not take into account other costs that may be associated with placing the bet. These additional costs can add up along with your losses and quickly turn into a major risk you cannot afford to maintain. 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.
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. 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. 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. 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. 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.
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