Forex Trading Tips: Martingale Like a Marketmaker

Martingale Like a Marketmaker

I have a friend who has been extremely successful at trading the equity market over the past several years. She managed to take a modest stake of $60,000 and run it up to nearly three quarters of a million in a period of less than 24 months by remaining unabashedly bearish. Unfortunately over the past four weeks she has seen her equity shrink to less than half as the market staged a vicious upside rally. Why did her fate change so drastically in such a short period of time? She martingaled without a stop.

A martingale is one of the oldest and most common strategies in both betting and trading but it is also the most dangerous. When you martingale into a trade, you add size to you position as price goes against you. The hope is that when the market turns you will have achieved a better average price and will be profitable much faster than at your original entry point. The idea is incredibly seductive, because it offers the prospect of a profit without the need of ever taking a loss. It’s the trading equivalent of a Tony Robbins lecture – the promise of happy and wealthy life without the need for work or sacrifice. Unfortunately it is also inevitably wrong.

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Aside from death and taxes there are few certainties in life, but here is one of them. In the long run a martingale strategy will bankrupt you irrespective of how much money you have. The markets, as John Maynard Ketnes once noted, can remain illogical longer than you can remain solvent. Ironically enough institutional traders fall victim to this strategy no less often than retails ones. Read the history of Goldman Sachs by Lisa Endlich and the story that repeats itself over and over again is how the firm comes within pennies of bankruptcy several times during its storied past as various traders including Bob Rubin lay on bets that nearly capsized the bank before markets finally turn around. Perhaps GS is the one exception – perhaps they do have more money than God and can ride out any adverse move they encounter. Perhaps, but I wouldn’t bet on it. In the meantime, from Long Term Capital to Amaranth history is littered with examples of martingale bets gone wrong.

So is there ever a way to matingale with success? Maybe, but it is not pain free. In the video below I discuss one possible strategy that tries to take advantage of the short term statistical edge of martingale betting while at the same time put an absolute stop on the amount of losses the trader should absorb. My method requires that traders cap their losses both intra-strategy and on the overall position. The net result is that you will produce a steadily climbing equity curve, only to encounter sickeningly large drawdowns. It is like building a skyscraper only to come to work one day and see the top 10 floors smashed to pieces forcing you to rebuild. Is It a Sisyphean task? Let’s hope not. Let’s hope that no matter how tough the drawdown you are able to stay above the foundation and ultimately build an ever rising edifice of profits.

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