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The Martingale system is one of the oldest known strategies, which is made use of while betting. The strategy can be used in any game, which has an equal probability of a win or loss.
In this strategy, the player doubles his bet every time he faces a loss. Consider a player bets on the toss of a coin. He bets Rs100 on tails in his first bet and the outcome is a head, his next bet is for Rs200 and he faces a loss again. The player then bets for Rs400 and wins. The flow of funds for the trader in this scenario would be (-Rs100 –Rs200 –Rs400 + Rs800) netting a profit equal to his initial bet of Rs100.
The player would end up on the winning side after a profitable bet no matter how many bets were losses prior to the wining bet.
Markets are not a zero sum game like betting on a roulette table, even though the stock makes a 50% correction, the trader still continues to hold a position, which is worth some amount. Hence, we have to modify the martingale strategy while applying it in stock markets. The payoff diagram would also end up being considerably different.
The strategy would be similar to averaging down. A trader buys stocks worth Rs1,000 at Rs50 and waits for it to go up. If the reverse happens and the stock moves down, the trader doubles his initial bet at Rs25, thus having a breakeven of Rs30. If the stock moves down further to Rs12.5, the bet size is doubled again so that the breakeven point now becomes 16.66. If the stock bounces to 16.66 the trader is in a no profit no loss situation and the trader is able to make a profit equal to the size of his initial bet i.e. 1,000 when the stock moves up to Rs19.04
Take the example of Unitech Limited
Consider a trader makes use of the martingale betting strategy and purchases Rs10,000 worth shares when Unitech Limited was trading at 100. The stock corrects in the following days and the trader makes a fresh purchase worth Rs20,000 at 50, thus taking his average cost to 60. The trader waits for a bounce but unfortunately the stock continues to slide lower and the trader makes fresh purchases worth Rs40,000 at 25. By doing so, the trader gets his weighted average cost to Rs33.33. The point at which the trader can successfully exit the trade by making a profit equal to his initial bet size as per the strategy is Rs38.10. The stock in the following days witnesses a bounce till Rs37 levels but the trader is not able to exit his position as per the martingale strategy.
The trader watches in disappointment as the stock corrects a bit further in the subsequent days. After a long wait the stock finally witnesses a bounce and the trader is successfully able to exit his position at 38.10 and in the process netting a gain of Rs10,000.
In the prior case, the trader was able to exit after his 3rd purchase, as the stock witnessed a bounce till 38.10. In case the trader is extremely unlucky and the stock never witnesses a bounce after his initial purchase, he would nearly go bankrupt executing the strategy till the time the stock is traded in the hope of a recovery. As shown in the above table, the trader would end up buying 2,07,12,61,833 shares worth Rs 8,19,10,000 by the time he makes his 13th purchase. The size of the bet is also 4,096 times the size of his initial bet, which in percentage terms comes up to 4095999900%. Average traders would not have this size of capital to execute the strategy till the end. Plus his entire capital has a chance of getting wiped off if the stock stops trading.
The bet size reaches mammoth proportions after the initial few bets.
If you run out of cash i.e. you have to make a premature exit from the strategy, your losses will be catastrophic.
The stocks could stop trading at some point in time.
The risk –reward ratio is not favorable. A player using the strategy keeps betting higher amounts with every loss. However, his final profit would be equal to his initial bet size. Incase his final trade is a loss, a significant amount of his capital will be wiped off.
The strategy does not take into account costs associated with every trade such as brokerage cost and impact cost, which becomes a significant figure as you increase your bet size.
There are limits placed by exchanges on trade size, an individual trader and broker can place in a single stock. Thus, the trader is not allowed infinite number of chances to double his bet, violating the basic requirements of the strategy.
The stock price does not move in fixed proportions. In our example of Unitech, the stock could have fallen from 100 to 60 and then moved to 120, but as per the strategy, we were allowed to double our bet only at 50, thus missing out on the opportunity.