Martingale and random trading

Martingale and random trading

Martingale is an age old “money management” system, that originated as a betting system in 18th century France. The idea behind it is simple: allow the trader to have huge, exponential growing drawdown, in order to regain lost capital ; the betting system rule is to double the stake when you have a loss.

The trick about the martingale is that it gives the impression that the probability of the next loss reduces as we advance thru a streak of losses. For instance, we had 6 losses and we ask ourselves what would be the probability to have 7 losses. If we note the states by L for losses and W for wins, then we’d have our 7 losses as one possibility (LLLLLLL) out of 2^7 (128) cases. That means 1/128. As we go further down, the number continues to shrink even more, as our drawdown increases exponentially.

 

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As you can see in the table, as you’re getting hammered by the exponentially growing drawdown, the probability for the ruin to continue is shrinking.
The problem is, however, that the possibility of a win after 6 losses (as in our case) is the same, still one possibility (LLLLLLW) out of 128 cases. That is, what matters is the individual probability of a win.

That means, in the case of a casino wheel, that the probability of the next loss is the same. There is nothing in the mechanics of the wheel to prevent losing in the future. The probability of a win remains constant (18/37) , 48.65% (one zero wheel case).

The probability is different than the one in the table, because the one in the table is calculated before the entire streak. Those 128 cases referred for the 7th tryout include also WWWWWWW or WLWWLLW for instance, but in the case of the martingale, the LLLLLL already happened, and the probability of the next tryout to be a loss is as much as the probability for the first one.
In trading, the situation is just slightly different. It starts out being basically the same. The market can go any of the two directions: either up, or down, with a 50% probability on both. That is, because the market moves randomly. You can see the same thing in the option theory: an ATM option will have a 50% delta to reflect the same thing. Or, if you trade binary options, the large majority of platforms out there are one click based – the option is created with the market price at the time of the click being the strike price of the option so that it starts as a bet, with a 50% chance.

To translate the martingale strategy in trading, we consider a single trade, with a take profit and a stop loss. Therefore can be only two events : either it touches the take profit or the stop loss.

One application of the martingale would be for the trader to try to exploit the momentum. When the momentum occurs, the probability – at least the perceived probability – of a move in a definite direction would be higher than 50%. That’s why we call it momentum – it’s when the market doesn’t seem random anymore. However, one has to ask, how much money would you leave on the table if momentum doesn’t pay off and you end up losing several steps in a loss streak ?

One important element that can influence probability is the spread. The smaller the spread, the more impact it has. Why ?

After you launch a trade, you will already be in the loss territory with trade (the spread will be there). Should you win, when you touch your target, you will have to touch Target plus Spread ; when you lose, you will just touch Target on the negative side. So a positive market movement will have to be larger than a negative one. How much ? By the spread. If your spread is 2 pips and you set your target at 4 pips, you will be halfway in the loss territory after you launch your trade. But if your target is 50 pips, then the win territory would be 52 pips – they would be almost equal.

If you want to bet on a direction and want to martingale it, this way is better than using binary options. You will get the 100%, full result of your trade. While, with binary options, you will be payed merely 80% to 85% for the same risk you take.

Another application of martingale would be to constantly switch the direction. Buy, sell, buy, sell, and so on. The market most likely wouldn’t be able to undo your every trade, and you might be able to finish in profit after a few attempts ; however, in rangy markets, this can become dangerous.

Finally, martingale can be attempted on low liquidity markets, for instance when the US session ends, and even after the beginning of the asian session. With carefully picked SL/TPs, martingale could be used, as the market will tend to range and revert at some point.

The attached martingale expert has a plethora of options for you. It gives you control over the trade parameters – Lot Size, Slippage, Stop Loss and Take Profit (SLTP), but it also gives control over the trading process itself. Thus, you may set an InitialDirection to 0 or 1 (if you want it to start with Buy or Sell) or to -1 (if you want random) ; a ContinuationMode which can be 0 (new trade is random type) ; 1 (trade is the same type as previous) ; 2 (trade is opposed type) ; a MaxConsecutiveLoss to limit the maximum loss per streak ; and even a StopAfterFirstStreak flag, which will prevent the expert from trading after it either finished in profit the first streak, or the streak was stopped out by reaching MaxConsecutiveLoss (or 0, to disable it – unrecommended). Finally, a StopHourFriday parameter to prevent the expert from taking new trades on Fridays from a given hour, in order to prevent an opening gap to the loss, on Mondays.

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By | 2015-06-09T09:32:08+00:00 June 9th, 2015|Blog|0 Comments

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