Martingale Systems and Why They Don't Work In Stock Trading
Written by OnlineLoan on 21:54Martingale Systems and Why They Don't Work In Stock Trading
By: Sachin Asher
The Martingale system is one of the oldest known strategies of betting.
It was initially developed for games like roulette, where there can be an equal chance of winning and losing. It can be used for other games with similar 50-50 chances and also can be modified for stock trading.
Consider a case of a coin toss, in which you have to correctly guess the result to win. You can either lose all the money that you bet, or double it, if your guess is right.
Your chance of a right guess are 1 in 2; or 50%.
In the Martingale system, the player doubles his bet every time he loses.
Suppose he bets 1$ on heads in his first bet. The outcome is tails. The next bet is for 2$ and is again wrong. Then the player bets 4$ and wins. In such a sequence the player's net winnings = (-1$-2$-4$+8$) = 1$.
The system will produce a net profit after a winning bet; no matter how many bets were lost prior to the winning bet.
Seems easy money - doesn't it?
Actually it is a recipe for a betting disaster.
Firstly, it is based on a fallacy that past events will affect outcome of future events in case of random events.
For example, what are the odds of getting 4 heads in four tosses of a coin?
1 in 16.
What are the odds of getting a head in a coin toss if earlier three outcomes were heads?
1 in 2.
Thus we cannot say that getting a head is less probable when the earlier three outcomes were heads. However Martingale system works on the fallacy that if a player was wrong on earlier occasions, his probability of being right increases with each bet and thus he should keep doubling his bet.
The second drawback is that the bet reaches mammoth sizes after the first few bets. The bets in a losing run would look like 1$, 2$, 4$, 8$, 16$, 32$, 64$, 128$, 256$, 512$, 1024$ and so on.
A player starting with 10$ bet would be betting 5120$ in the tenth bet. This may be greater than the permitted limits in some cases.
Third disadvantage is the risk - reward ratio. A player using the Martingale system keeps betting higher amounts with every loss. However his final profit would be 1$ - no matter how many bets he makes before the winning bet. In the long run his final loss will take away all his profits and much more.
The Martingale system can also be implemented in Stock trading. The trader would keep doubling his position size till he makes a winning trade. This system has the same drawbacks as mentioned above. There is no way one can predict the number of successive losing trades that will take place - which means the risk, will keep increasing with each trade, but possible reward is limited to the position size of the first trade.
A Martingale system in stock trading faces certain practical problems.
1. There are costs involved with every trade. There is a brokerage to be paid and in certain markets there are taxes on each transaction too.
2. There is an impact cost involved with every trade. You may not get all shares at the best offer rate and you may have to increase your bid. Similarly you may not be able to sell all your shares at the best bid rate and you may have to decrease your offer. Thus the profit (loss) in each trade is less (more) than theoretical one.
The impact cost keeps going up as you increase you lot size.
3. There are limits placed by exchanges on exposures of individual traders and brokers. Thus a trader using Martingale system is not allowed an infinite number of chances for doubling his trading lot - violating the basic requirement of Martingale system.
The Martingale system is an illusion. The player (or trader) keeps taking bigger and bigger risks in search of a winning turn; disregarding the fact that his net win is always going to be an amount equal to his first bet.
It was initially developed for games like roulette, where there can be an equal chance of winning and losing. It can be used for other games with similar 50-50 chances and also can be modified for stock trading.
Consider a case of a coin toss, in which you have to correctly guess the result to win. You can either lose all the money that you bet, or double it, if your guess is right.
Your chance of a right guess are 1 in 2; or 50%.
In the Martingale system, the player doubles his bet every time he loses.
Suppose he bets 1$ on heads in his first bet. The outcome is tails. The next bet is for 2$ and is again wrong. Then the player bets 4$ and wins. In such a sequence the player's net winnings = (-1$-2$-4$+8$) = 1$.
The system will produce a net profit after a winning bet; no matter how many bets were lost prior to the winning bet.
Seems easy money - doesn't it?
Actually it is a recipe for a betting disaster.
Firstly, it is based on a fallacy that past events will affect outcome of future events in case of random events.
For example, what are the odds of getting 4 heads in four tosses of a coin?
1 in 16.
What are the odds of getting a head in a coin toss if earlier three outcomes were heads?
1 in 2.
Thus we cannot say that getting a head is less probable when the earlier three outcomes were heads. However Martingale system works on the fallacy that if a player was wrong on earlier occasions, his probability of being right increases with each bet and thus he should keep doubling his bet.
The second drawback is that the bet reaches mammoth sizes after the first few bets. The bets in a losing run would look like 1$, 2$, 4$, 8$, 16$, 32$, 64$, 128$, 256$, 512$, 1024$ and so on.
A player starting with 10$ bet would be betting 5120$ in the tenth bet. This may be greater than the permitted limits in some cases.
Third disadvantage is the risk - reward ratio. A player using the Martingale system keeps betting higher amounts with every loss. However his final profit would be 1$ - no matter how many bets he makes before the winning bet. In the long run his final loss will take away all his profits and much more.
The Martingale system can also be implemented in Stock trading. The trader would keep doubling his position size till he makes a winning trade. This system has the same drawbacks as mentioned above. There is no way one can predict the number of successive losing trades that will take place - which means the risk, will keep increasing with each trade, but possible reward is limited to the position size of the first trade.
A Martingale system in stock trading faces certain practical problems.
1. There are costs involved with every trade. There is a brokerage to be paid and in certain markets there are taxes on each transaction too.
2. There is an impact cost involved with every trade. You may not get all shares at the best offer rate and you may have to increase your bid. Similarly you may not be able to sell all your shares at the best bid rate and you may have to decrease your offer. Thus the profit (loss) in each trade is less (more) than theoretical one.
The impact cost keeps going up as you increase you lot size.
3. There are limits placed by exchanges on exposures of individual traders and brokers. Thus a trader using Martingale system is not allowed an infinite number of chances for doubling his trading lot - violating the basic requirement of Martingale system.
The Martingale system is an illusion. The player (or trader) keeps taking bigger and bigger risks in search of a winning turn; disregarding the fact that his net win is always going to be an amount equal to his first bet.
Article Source: ABC Article Directory
Sachin A. is a freelance writer. Find more on trading systems and finance at www.articlemanual.com
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