Most retail traders have issues accepting losses. As such, their entire quest in the trading world is about discovering, creating or learning a trading strategy that has the highest win rate possible.
Welcome to the world of Martingale trading models.
The equity curve of martingale trading models is easy to spot: it has a typical 45° upward slanted curve which looks very smooth and has these occasional “blips” to the downside.
Most traders on the retail side love this kind of trading strategy because they almost never lose….except that when they do lose, the losses are huge. In the end, most traders that attempt to trade a Martingale strategy end up like this:
Make no mistake: there is no shortcut to becoming a consistent trader that can qualify for funding. And actually, Martingale trading strategies are something we don’t particularly like to see - because our experience tells us that sooner or later the trader will blow up.
There is a better way to trade, but let’s build up our understanding of the Martingale strategy from the bottom-up.
What is a Martingale Strategy?
Martingale is a probability theory of fair game which was developed by a French mathematician, Pierre Levy in the 18th century. From a trading perspective, a Martingale approach involves doubling your position size every time a loss is incurred.
Taking the example of a simple heads and tails of the coin flip, in a Martingale approach, every time there is a loss, the next bet is doubled, in hopes to recover the losses as well as gain one up from the loss.
Example: Coin Toss Game. Risk $10 on each flip. If heads, win $10, if tails, lose $10. Double the position size (the Martingale component) on each loss.
Heads +$10
Heads +$10
Tails -$10
(Now the position size doubles to recover the loss)
Tails -$20
(Now the position size doubles again to recover the losses)
Heads +$40
Total = +$30
As you can see from the basic example, it can be a very profitable yet very risky way to trade the financial markets because there can be long streaks of losing trades, which would require the trader to continue doubling his position size and incur the risk of running out of capital before he can actually recover the losses!
As such, a pure Martingale system can’t exist in the real world because it means having an unlimited account balance and an unlimited amount of time to recover the losses. In a real trading system, you need to set a limit for the drawdown of the entire system.
As such, you are restricting your loss recovery and are no longer using a pure Martingale system. And in doing so you’re using an approximation that will always have a failure point.
This is why the only kind of semi-Martingale strategies that work for any length of time use a combination of:
non-directional markets (so there won’t be runaway trends that create strings of losses);
minute position size compared to the account balance (so the account can withstand the drawdowns and the margin requirements of the recovery trades).
There are Only 2 Kinds of Trading Strategies
Independently from the instrument you trade (Dax, Gold, FX, etc):
Negative Skew strategies: if you scalp for a few pips, but have a 100 pip stop loss; if you are selling out of the money options; or if you trade mean reversion, you are running a negative skew strategy. All these strategies “pick up pennies in front of a steamroller”. For a while, these strategies will show low volatility consistent performance most of the time, but will break down during “tail events” (i.e. unexpected events, statistically improbable losing streaks, spikes in volatility, etc).
Positive Skew strategies: if you are attempting to “let your profits run and cut your losses”, if you are attempting to follow momentum or if you are playing breakouts in the direction of a trend, you are running a positive skew strategy. Positive skew strategies are hard to run, because they usually have a low win rate, but they offer the benefit of achieving big winning trades. The issue of positive skew strategies is the lower win rate.
Here is a visual representation of the distribution of returns of each strategy:
So whenever you see an equity curve like this:
realize that you are looking at a negative skew strategy.
Typical Account Metrics of a Negative Skew Strategy
Another way to spot a negative skew strategy is to look at key account metrics:
the Win%: be cautious of any strategy which wins over 80% of the time. Most Martingale strategies and Negative Skew strategies have these high win rates. Know that professional traders rarely have a win rate above 50%.
Average Profit/Average Loss ratio: one thing we look for here at FCI when selecting traders is the Average Profit/Average Loss ratio. This tells us a lot about how skilled the trader is at running profits and cutting losses. If the Average Profit is not much larger than the Average Loss, essentially the trader’s profitability hinges on his win rate. And that is not a good place to be. We want to see traders have profits that are, on average, 2-3x the size of a typical loss. Instead, most Negative Skew strategies and Martingale strategies have profits that are smaller than losses.
Consecutive Win Amount vs. Consecutive Loss Amount: Negative Skew strategies and Martingale strategies can have long winning streaks, but give back all that profit (and more) during the losing trades. For example, if you have 30 winning trades in a row that make you 3000 USD, and then 1 loss takes back 1500 USD, automatically we know it takes on average 15 profitable trades to make back 1 loss. So, on average, each profitable trade is worth 1/15th of a loss and the Average Profit/Average Loss is realistically 0.06 instead of 2 or 3.
To get a feeling of what kind of life you can enjoy as a Negative Skew trader, read up on the fate of LTCM, perhaps the most famous negative skew hedge fund the world has ever seen.
Exploring a Martingale Trading System
Now that we know how to spot a Martingale strategy or, more broadly speaking, a Negative Skew strategy, we need to understand why traders still employ them and why many retail investors are so attraced to them.
Here’s why:
The constant stream of profits just acts as a magnet and the manager, as well as the investor, feel like Gods. These strategies can rake in profits for months, when market conditions are relatively smooth and a large enough trading account is used.
The reality however is that systems like these have also ruined many small accounts where the users failed to understand the risks of this strategy. In particular:
- the expected volatility of the market over the next 10–20 days;
- the amount of leverage used by the system to “recover losses”.
In this particular system, we notice that the manager finally took a loss (92 pips) which is 30x larger than the average profit (3 pips). This means that the manager keeps trades open with a large stop loss.
The first thing to notice is that the large stop loss means that losses will always be larger than profits and that the trading account needs to be large just to be able to absorb this kind of loss!
But it doesn’t end there: the algorithm engages in a “loss recovery” mecchanism using a Martingale position sizing tactic. Since the probability of having a win is high for this kind of system, the manager uses a Stop & Reverse tactic, employing a position size that is 7x the size of the original trade, hoping to have a win.
So first of all, the investor has just absorbed a 92 pip loss. Now the account holder sees the manager open up a huge position in the opposite direction. The account will face a margin call unless there is enough margin left in the account to support the huge position size on the recovery trade.
But that’s not all: the account also needs to sustain the volatility of the actual recovery trade, which is in the market for 6 DAYS!
A lot can happen in 6 days, and having an outsized position open for that length of time would make any trader nervous because the swings in the account’s equity will be enormous.
Food For Thought
In this first article we have covered the basics of Negative Skew strategies, which include Martingale trading strategies. We have assessed the real risks of this kind of trading method and now you should have a deeper understanding of why so many traders that attempt this kind of strategy, eventually blow up.
In the next article we shall answer the question: is there a “safe way” to trade a martingale system?