Martingale and Risk Management

Martingale is and old strategy used in the world of betting that consists of doubling our bet every time we lose.

The objective is trying to recover what you have already lost in the previous bet by betting a bigger amount until you recover all your previous loses.

Martingale betting system

The basic feature of this “system” consists on the fact that people think that the probability of having a winner is bigger after you have had many consecutive losses.

That, evidently, and as long as we are doing random betting systems like rolling dices or flip coins, is a fallacy. And, even in those day trading bets, like the famous 60 seconds binary options markets, are those kinds of markets.

People who trade those markets think they are doing some sort of sophisticated game, but the only thing they do is going bust at a very high rate.

In the random betting systems, the probability of success is the same as the probability of failure.

Martingale flipping coins

Flipping coins or rolling dices gives us good examples. In the first case the probability of success is 1/6 and in the second case, ½.

Therefore, we will always have a ½ chance of being right any time we flip a coin, which means that we do not have any edge if we think that the chance of being right is bigger after five or ten bets. After ten bets, the probability of being right is still ½.

Things change when we are in the presence of processes where praxeology (human action) plays an important role. In those cases, random probabilities stop being the norm. The chances change, and there are certain outcomes of different policies or behaviors. It is as if we could see our opponent cards without him noticing it.

Martingale bet

Just imagine the Spartan army two thousand years ago.

It had won twenty consecutive wars, but its army was reduced by 90% due to casualties. It is quite likely that in the next war, provided that the enemy is strong enough, the Spartan army will lose, even though that army would have defeated without problem the same enemy in the past, before it had so many casualties.

Probabilities change when societal conditions change.

Society is not static, the state lottery is.

Martingale edge?

The martingale strategy does not give us any edge when we are doing betting random activities.

However, it does not mean that we should consider the use of martingale strategy in long term investing, even though we know the probability of a certain outcome is higher than 50%.

In fact, we should never use martingale, in any case.

Something that should be quite clear also, is that we should never bet in random betting games like dices, coins, slot machines, etcetera. All the edge is on the side of the “house”.

Martingale in financial markets

In financial markets, and in the so-loved day trading communities, occurs the same.

The edge is on the side of the house, which means that we should not try those strategies with or without martingale.

One of the fundamental rules of professional trading or betting is not to bet more when you lose, but when you win.

On the contrary, we should bet less when we lose.

Martingale risk management

We should bet a tiny percentage of our account on any single bet, ideally the same percentage, for instance, one percent.

Remember, that a legend like Bruce Kovner reminded us that we should not bet more than 1% of our account in each trade.

After many years, I have come to the same conclusion. We should not risk more than one percent every time we trade or bet. Ideally, it should be between 0 and 2.

For instance, if we have a 10.000$ account, if we bet the 1%, we should play with 100$, so if we lose, we end up with 9.900$, and our next trade should risk no more than 99$. Doing so, we would be protecting our capital with a risk management strategy used by professionals. We should never look for that “revenge” trade, trying to recover what we lost in previous “unlucky” bets.

Evidently, there are small accounts that can not apply the same risk management as a 100.000$ account can, but we can always try to do it as professionally as possible.

If we use a martingale system in the example named before, we should lose 100$ the first trade, and then 200, then 400, 800, 1600, 2400, and kaput, our account is done. As you see, after seven trades you can destroy your account even though you started betting 1% of it in the first trade.

Having seven consecutive loses is quite normal in trading, so we can see how dangerous and ridiculous martingale strategies are.

Thanks for reading and sharing.