The Martingale Trading System

Today in less than 5 minutes:

1) Theory of mean reversion
2) The Martingale Trading System
3) Martingale vs. Anti-Martingale

Theory of Mean Reversion

Have you ever driven along a winding mountain road?

You might have noticed that your car tends to veer off course when you accelerate too quickly or brake suddenly. Yet, no matter how far you stray, there's always a force pulling you back toward the center of the road.

This force resembles the concept of mean reversion in the stock markets, where prices tend to revert to their average value after significant deviations.

Notice the below chart of the NIFTY IT index, and how the prices are treating its 200-DMA as support, always reverting to it after a jump:

A concept taught in 8th grade, mean reversion is not only seen in stock prices but also applies to volatility, earnings, trading strategies, and a range of different indicators.

If applied well, this theory can be used to generate excellent returns from the stock market as well as other asset classes.

In today’s issue, we will be learning a unique, but risky, trading system that has its roots in mean reversion ↓

The Martingale System

Based on the theory of mean reversion, the Martingale system assumes that you will eventually win even after a string of losses.

The strategy involves doubling the trade size after each loss, aiming to cover previous losses and generate a profit with the next successful trade. 

For instance, if you start with a ₹10 trade and lose, you double your capital to ₹20 on the next trade, and so on, until you win. The profit from the winning trade is expected to offset all previous losses, and then you restart with the original trade size of ₹10.

How to deploy the Martingale system

1) Deploy an amount you are ready to lose without hesitation. If you will remain unaffected by giving away 5% of your total capital, then it’s ideal to not deploy more than 5%. We suggest you start with 2%.

2) Determine the technical strategy you would like to deploy. The strategy should have a win rate of at least >50%.

3) Choose the stock / index you would like to deploy this in. Studies show that this system is well-suited for stocks and asset classes characterized by frequent sideways movement, as it can effectively capture more instances of mean reversion.

4) If a winning trade occurs, reset to your original trade size but if it's a losing trade occurs, double the size for the next trade until a new winning trade is achieved. Expert traders recommend discontinuing the strategy after 3 winning trades have been achieved.

5) Make sure you are following a sound strategy with the right entry, exits, and stop losses.

The Martingale Strategy will fail if you don't have the capital to see it through until your investments experience a reversal, which makes it pretty similar to gambling.

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Will you use this strategy?

The Maritangle system is risky to deploy but can be useful. Tell us, will you try using this strategy?

Martingale vs. Anti-Martingale

There exists a system that is the opposite of the Martingale system. Aptly called the anti-martingale system, this system is a methodology to amplify winning streaks and minimize losing streaks.

Here, a trader would double up on winning trades and reduce the amount in case of losing trades 😇

We also found a study that explains the return characteristics of the two systems in discussion:

Martingale vs. Anti-Martingale

Upon studying the returns from the two systems, the following conclusions can be made:

• Returns from the Martingale system appear as fat tails characterized by steady, positive returns and ‘one-off’ losses. The anti-Martingale system, on the other hand, has lower variance and its returns are more clustered around the mean.

• The Martingale system is suitable for flat, sideways markets while the anti-martingale system is most suited for volatile, trending markets.