In our first article we covered the basics of Negative Skew strategies, which include Martingale trading strategies. We 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 this second article we are going to find out whether there is a “safe way” of operating a Martingale trading strategy at all, and whether the inherent risks of the Martingale trading strategy can be hedged at all.
Trading = Managing Risk First
To assess the feasibility of a Martingale strategy, the best place to start is from the Maximum Drawdown Limit.
When thinking about Maximum Drawdown Limit, we need to remember that our trading capital is divided into 3 parts:
- the risk capital for the trade at hand;
- the margin requirement for the open position;
- free capital left in the account.
Let’s imagine a £10.000 account, with 100:1 leverage (typical at FCI Markets). Imagine opening a standard lot (100.000) on GBP/USD at 1.3350, with a stop loss of 50 pips. Here’s how the account is split up:
- risk capital for the trade at hand: 374 Pounds [(50 pips * 10 USD/pip)/1.3350]
- marign requirement: 100.000*1.3350 = 133.500 / 100 = 1335 Pounds.
- free capital: 10000 - 1335 - 374 = 8291 Pounds.
It’s important to know this because with Martingale strategies, you will be doubling down (or more) after each loss. This means the margin requirement doubles after each loss. This is why small accounts suffer so much when trading Martingale strategies: they usually forget about the margin requirements!
So let’s go through an exercise to determine the maximum open lots that a £10.000 account can risk using a standard Martingale strategy:
1 loss = - 374 Pounds (at current GBP/USD price); account balance = 9626 Pounds.
Now we double down, and hypothesize another loss:
2nd loss = 748 Pounds; account balance = 8878 Pounds.
Now we need to double down again, which means 4 Lots of GBP/USD. Now things are getting tight as we have 4 * 1335 = 5340 Pounds of margin locked up, and only 3538 Pounds left of risk capital.
3rd Loss = 1496; account balance = 7382.
Unfortunately we cannot proceed further to double down, because we wouldn’t have enough space in the account to withstand the loss AS WELL AS the margin requirement for 8 standard lots of GBP/USD.
So our limit is 8 lots which are 3 Martingale Legs. The relationship is as follows:
- max lots = 2^Number of Legs
- And the number of trades that you can handle will be (2^Number of Legs)+1
Which allows you to understand the most important equation of all: the Maximum Loss = [(2^Number of Legs) - 1]*stop loss distance (in pips).
So with 3 possible legs, and a 50 pip stop loss as above, would give a maximum loss of (2*2*2 - 1)*50 = 350 pips….which really isn’t much!
That’s why most martingale systems are used with very small position sizes, so the trader is able to survive many legs (or use much higher leverage on the recovery trade).
Typical Martingale Tactics
Here are 2 examples of what typical Martingale trading tactics.
The first is cost-averaging.
At FCI we don’t like this tactic for 3 reasons:
- the trader is fighting a trend or momentum move;
- the trader is adding to a losing position;
- the trader is locking up capital that should be used on better opportunities.
So if you see charts like these, you know what kind of strategy is being used.
The second tactic is commonly used in “Drawdown Recovery” tools. After a big loss, the trader opens up an opposite order using higher leverage, in order to recover the drawdown in 1 trade.
So, Martingale tactics create an illusion that you can avoid making losing trades. But the problem is that a large lot size results in a huge risk. If you continue to fight a trend, or if your drawdown recovery trade doesn’t work, the entire account is lost.
Invisible Risk
The final aspect to cover has to do with the risk which the investor must sustain during the life of each trade. Since Martingale systems hold losing positions for extended periods of time, and actually add to losing positions, there is an element of risk that is not captured by the standard risk measures.
Most risk measures only take into consideration closed trade statistics. It takes an analysis of MAE/MFE (Mean Adverse Excursion/Mean Favourable Excursion) to better evaluate the solidity of a trader’s approach.
The chart above shows the MAE/MFE distribution for a Martingale system. Notice the difference in the positive scale (Max 45 pips) and the negative scale (Min 100 pips). This system scalps for a handful of pips each trade, but during the life of the trade, the adverse excursion can reach 90+ pips before the system closes the trade.
As a matter of fact, if we observe the life of each trade before it’s closed, the actual path of the investors’ equity will most likely look like the red line in the picture below.
There is much more risk to this kind of trading than meets the eye.
Over to You
Sadly, Martingale systems just don’t cut it. They are fundamentally different from other Negative Skew strategies such as Out-of-the-Money option selling or Pairs trades, because the entire focus is on “money” and not “the system”.
The entire focus of Martingale traders is “not losing money”. There is usually very little interest in actually creating a profitable trading strategy that would generate consistent performance without any strange money management strategies.
Vice-versa, the Negative-Skew strategies employed in the professional space are based on sound rationale…and they can also cause massive losses even without using Martingale position sizing!
The bottom line is that proper trading is about delivering superior risk-adjusted returns. There is no shortcut unfortunately, but there are some rather simple approaches that can get you on the path to consistency, without risking your entire account on any single trade or combination of trades.
If you’re interested in crafting proper trading habits, this is a good place to start.
Good Luck!