Trading the market requires managing many different moving parts. This includes deciding which instruments to trade, which time frames to trade those instruments, what strategy to implement, how much to risk on a given trade, and what the trade management process should be like. Here, we will focus on the question of how much to risk on a trade. And specifically, we will view risk from the perspective of the Martingale betting system and the Anti-Martingale betting strategy.
What is A Martingale System?
The Martingale system is a well-known method of making bets. It was originally intended as a gambling system, however it can be applied to financial market speculation. This includes the Forex, Futures, Options, and Stock markets alike. At the basic level, the Martingale betting strategy seeks to double the size of each fixed losing bet, and continue this process during the sequence of losing occurrences, until a winning occurrence comes that ultimately recovers all of the previous losses.
So the illustrate this idea better, consider a gambling game like roulette. We will assume a fixed bet of $100 per spin of the roulette wheel, and a bet of the wheel landing on red. As such, every time the spin results in the wheel landing on red, you will win $100. Similarly, every time the spin results in the wheel landing on black, you will lose $100. Based on the Martingale system, when the result is positive, that is that the spin of the wheel lands on red, you win $100, and will start all over again with a new $100 bet.
On the other hand, if the result is negative, that is that spin of the wheel lands on black and you lose $100, you will double your bet on the next spin, which is equivalent to making a $200 bet. Now if this third spin also results in a loss i.e. landing on black, you will again double your bet size now risking $400 on the next spin. This process will continue for as long as it takes to end up with a positive result i.e. the spin of the wheel landing on red. And when that does occur, you will recoup all of the losses that you incurred during the losing streak.
Let’s now adapt this Martingale money management style to a trading application. Assume that you are taking a position in the Forex market in the EURUSD currency pair. Your trading strategy has a one-to-one risk to reward characteristic, and you typically risk $200 per trade. Well in this case, every winning trade will result in a $200 profit, while every losing trade will result in a $200 loss.
Every time you realize a positive result i.e. a winning trade worth $200, then you will look to risk $200 on the next trade set up that occurs. However, if you realize a negative result i.e. a losing trade where you lose $200, then you will double your bet size and risk $400 on the next trade. This could mean simply doubling your lot size from one lot to two lots. If on this trade you lose as well, then you would again double your bet size and risk $800 on the next trade. This could mean doubling your lot size from two lots to four lots. And so on and so forth until you realize a winning trade. And when that winning trade occurs, you will be able to recoup all the losses that you incurred during your drawdown period.
Now in theory, this seems like a no lose money management system. But as we all know, theory tends to work differently than practice. For example, the Martingale trading system does not take into account the emotional toll that such a strategy takes on the trader or gambler.
Based on the Martingale Forex strategy described above, if you had just five losing trades in a row which is not out of the realm of possibility for most trading systems, then you would be required to risk $6400 on the sixth trade that you take. That would take a phenomenal amount of courage and resilience from a trader who was initially only exposing themselves to a $200 loss on the trade.
Aside from the obvious psychological hurdles associated with a Martingale trade management system, it is also a bit flawed from the perspective of assuming that a trader is likely to have a huge bankroll to effectively double the risk exposure with each losing trade. As we mentioned, if you starting out with a $200 initial risk, by the time you’re at your sixth trade, following five consecutive losers, you will need to have the capital to take on a $6400 risk on the trade. And assuming that the sixth trade was a loser, then by the seventh trade you would need $13,800 of risk capital.
As such, the Martingale system presents practical challenges due to the financial limitations most traders have. And assuming that a large trader such as a hedge fund or banking institution has the means to engage in a Martingale approach, there will be other limitations that will eventually wreak havoc on the strategy. More specifically, due to issues related to trading volumes, and trade size limits at various exchanges, the Martingale strategy could eventually lead to a situation that is not feasible in the real trading environment.
Let’s now look at a final example of a Martingale system. This time it will be applied to shares of stock. Let’s assume that you purchased 100 shares of Apple stock which is currently trading at $200 share for a total investment of $20,000. You intend to use a Martingale method every time the stock falls by 50%. As such, if the price of Apple were to fall by 50%, then you would be required to purchase $40,000 worth of Apple stock at $100. This will reduce your overall cost basis with an average price at $120 per share.
If Apple continues to fall by half from $100 a share to $50 a share, then you would need to purchase $80,000 of the stock at $50 a share. This would result in your average stock price being $66.66. From here, if the price of Apple begins to rise, and reach the $66.66 a share level, then you will have realized a breakeven situation. In this example using the Martingale system, a stock trader was able to double down at the stock’s 50% drawdown level, and substantially lower their cost basis along the way. And then finally when the stock was the ready for a rebound, then it was possible for the Apple investor, in this case, to recoup all of their losses on the trade.
What Is An Anti-Martingale System?
The Anti Martingale system is the inverse of the Martingale system described earlier. This betting system calls for reducing each bet by half following every losing occurrence, while increasing each bet by doubling it following every winning sequence. Because of the characteristics of the Anti-Martingale system it is often referred to as a reverse Martingale.
Based on the Anti-Martingale system it becomes obvious that this betting methodology helps magnify the overall profits during a winning streak, while minimizing the overall losses during a losing streak. This system allows for increased risk as the account portfolio grows, while capping risk as the account portfolio enters into a drawdown phase. This strategy is much better aligned for use in the financial markets then the Martingale system. It is a logical money-management model that has much more practical use for a trader.
Many trading strategies and systems within the Forex and Futures markets are based on some variation of the Anti-Martingale approach. That is to say that many swing trading and trend following models tend to be quite conservative in their position size allocation when the system has been experiencing a series of losses.
Similarly, when the trading system seems to find the right environment and is benefiting by realizing a series of winning trades and capital appreciation, it will allow for more risk to be taken.
A fixed fractional trading model is a variation on the pure Anti-Martingale methodology. That is to say the concept of a fixed fractional money management approach is based on the idea that a certain fixed percentage of the account portfolio should be risked on any given trade. Now, that fixed fractional percentage could vary but is typically in the 1% to 4% risk per trade range.
Based on these characteristics, as the account grows a larger dollar amount of risk will be allocated to each trade, and as the account size decreases a smaller dollar amount of risk will be allocated to each trade. This is because although the same fixed fractional percentages are utilized, the actual dollar amounts will be higher at higher levels within the equity curve and reduced at lower levels within the equity curve.
If you’ve been in the trading world for any period of time, you will certainly be familiar with the age old axiom that says that “You should let your winners run, and cut your losses short”. This is exactly what an Anti Martingale trading strategy is based on. Although in the strictest sense the Anti-Martingale system calls for doubling after a positive outcome, and halving after a negative outcome, we can modify that in different ways within the context of trading and still maintain the basic tenants within this methodology of allocating risk.
One of the best environments to apply an Anti-Martingale strategy is during trending phases. When the market begins trading directionally either up or down, there is a tendency for that momentum to persist, leading to additional gains to the upside in the case of an uptrend, or to additional decline in prices in the case of a downtrend. And so, as you begin scaling into positions in the direction of the trend, you will be increasing your overall position as the trade moves in your favor. When you get aboard the right trend early enough, this can lead to a dramatic increase in profits on the trade.
The Anti-Martingale based system is the preferred method for allocating risk within a trading account. Traders will need to fine-tune the strategy to meet their specific goals, nevertheless, it’s well worth the effort to do so. The Anti-Martingale strategy does not suffer from many of the limitations that a Martingale based strategy suffers from.
Most importantly, it reduces the drawdown risk rather than amplifying it as is characteristic of Martingale methods. Most experienced traders realize that one of the most important components to success in the market is a trader’s ability to manage risk. The Anti-Martingale system has built-in mechanisms for reducing risk per trade, and thus ultimately reducing the risk of ruin of your trading account.
An excellent real life example of the enormous gains that can be realized from an Anti-Martingale trading strategy is the Larry Williams story. If you’re not familiar, Larry Williams is a veteran futures trader that has spent a lot of time analyzing and applying various money-management techniques in the market.
In a futures trading contest called the Robbins World Cup of Trading Championship, he was able to turn a $10,000 account into $1.1 million within just 12 short months. That equates to a phenomenal 11,300% return which was the highest ever on record for this trading championship, and most likely for any others held to date.
Mr. Williams attributed the huge gain primarily to his money-management strategy which was based on an Anti-Martingale trade system. We should not take anything away from his market analysis skills, which are quite remarkable as well, however, as he has opening admitted, the actual returns posted were largely a result of his aggressive Anti-Martingale position sizing scheme.
He was essentially using what is now known as the Kelly formula. The Kelly formula calculates the optimal bet size based on various factors such as your win amount of loss amount ratio, average win percentage and account size. It will seek to maximize the long-term growth rate of your account while trying to minimize the risk of ruin.
Since then, Larry Williams has turned several smaller accounts into very sizable accounts using variations of the Anti-Martingale money-management system. In fact he has also taught his daughter Michelle Williams to do the same. And she has gone on to make several fortunes of her own in the market using a similar approach to account growth.
We have detailed the different characteristics of a Martingale approach to trading the markets, and the Anti-Martingale method. The Martingale method has a characteristic of increasing risk exposure as a trader’s drawdown increases. On the other hand, the Anti-Martingale system seeks to increase risk capital only as profits grow, while reducing risk capital as losses stack up.
From the perspective of gambling games the Martingale strategy tends to be more popular, especially among those looking for foolproof ways to beat the casino. Although in theory the Martingale strategy looks good, there are many practical challenges to using it successfully in both the casino setting and the market setting.
Most traders should build money management systems that are based on an Anti-Martingale philosophy. This is because the primary job of a trader is to contain risk and the Anti-Martingale system by its very nature forces the trader to cut back on risk at the very times that the account is in jeopardy of realizing sustained losses. And at the other end of the spectrum, it requires a trader to go into a more aggressive mode as their capital grows, allowing them opportunities for outsized gains when a favorable sequence of trades is realized.
While there are different variations on the Anti-Martingale theme, one of the easiest ways to start implementing it in your trading is by adopting a fixed fractional position sizing model. We have touched upon this earlier, but essentially a fixed fractional model will limit risk to a predetermined risk percentage on any given trade. The recommended fix fractional percentage is 2%. Some traders may find this to be a bit conservative, however, generally speaking, it provides for the best combination of upside potential and limited risk of ruin scenario.
In addition to this, traders should implement some form of trailing stop mechanism so that they are able to extract the largest amount of profits from a winning trade. This also falls into the category of an Anti-Martingale mindset, which is to say, every attempt should be made to compound gains when we’re ahead of the game, and conversely, to minimize losses whenever we are behind in the game.