The Danger of the Martingale System in Forex

Risk management is the backbone of trading a successful portfolio of financial instruments.  The risk you assume when you place a trade is directly correlated to the reward you would like to achieve.  As your risk increases, the reward you expect to achieve may also increase, and finding the optimal capital to risk will be tantamount to generating a successful trading strategy.

Risk refers to the possibility of loss of capital. If you purchase a currency pair or commodity then you are subject to the risk of loss. The loss itself is not the risk; instead the possibility of loss is the risk. There are a number of techniques to control risk, and the amount that you place on a trade is one of them.  To achieve the optimal portfolio, investors might need to determine the most efficient amount of capital to use when making an investment decision.  There are a number of strategies that can be used to determine the best size of an investment.

A key component of determining your risk is to clearly define how much you are willing to lose on a portfolio basis. One school of thought says that if you are only willing to risk 20% of your portfolio then don’t expect to gain more than this.  A strategy where you could lose all the money in your portfolio is a dangerous strategy and should be avoided.

Martingale Betting Strategy

One strategy is known as a martingale strategy. This type of system is based on the idea that you will double your bet after losing trades, and in theory you will always cover your losses with winning bets that are double the amount of the losing bet.  The strategy is geared to systems where the chance of winning is equal to the chance of losing.

There are number of substantial risks an investor could face with a martingale strategy when trading forex.  One of the issues with forex price movements is that they usually consolidate and then trend.  While currency pairs usually only trend approximately 30% of the time, if you are caught on the wrong side of a bet during a trending market, a martingale strategy may generate the risk of ruin.

For example, assume you have a portfolio of $200.  If your first trade is a loser where you risked $20, it would only take 4 consecutive losing trades for you to lose all of your capital (-$20, -$40, $-80, $-60).  Since you would only have $60 dollars left on your 4^th trade you would bet what was available.

A second danger in using a martingale system when trading forex is that most brokers supply substantial leverage which means small movements in a currency pair might also drive substantial losses.  Many brokers offer leverage of 400:1, but even 50:1 could be harmful.  For example, if you have a portfolio of $200 and you buy EUR/USD using $50 at leverage of 50:1, a 2% change would eliminate your capital (50*$50 = $2,500 *2% = $50).  In this case 3 losing trades in a row would eliminate your capital.  Although a martingale system might work well in roulette, it presents substantial risk in the forex market.

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This article is a guest blog written by easy-forex