Despite the fact that we will start analyzing the trading approaches and building our own strategies only in the next level of this course, which will start from the next lesson, right now we will study one of rather popular approaches to trading. I decided to create a lesson on the averaging and the Martingale strategy right after the topic of risk management. Soon you will understand why.
This tactic can indeed be called relatively lossless, since, for it, 100% of profitable trades constitute a normal situation. Running ahead of the story, it is necessary to immediately say that one failed trade kills the trade deposit and the trader’s self-esteem along with it.
THE PRINCIPLES OF MARTINGALE SYSTEM
We will consider the Martingale system as a system of manipulation in the forex market but, traditionally, it has appeared as a way to win playing roulette without the risk of loss.
The essence of the strategy lies in the following rules:
- The player bets on one of the two roulette colors (for example, red) a minimum amount (for example, $10);
- In case of winning, the player changes the color and makes a minimum bet again;
- In case of losing, the player DOES NOT change the color and increases the bid twice (in our example: $20 for the red color).
Let’s count what will happen if the player loses 5 times in a row.
- $10 — we lose
- $10*2 = $20 — we lose
- 20*2 = $40 — we lose
- 40*2 = $80 — we lose
- 80 *2 = $160 - we lose
All in all, for 5 deals we have lost 10 + 20 + 40 + 80 + 160 = $310. The player continues to play, doubles the bet and bets on the same color.
Winning the sixth time, he returns $310 for one deal, fully winning back the loss for all the previous rounds. After winning, the player changes the color and starts again from $10.
THE DISADVANTAGES OF MARTINGALE STRATEGY
They key is that casinos are able to recognize such strategies and they do not allow players to win. Electronic roulette easily recognizes regular patterns, and in real casinos you can simply be ejected from the game. The Martingale principle of doubling is interesting to us, however, first of all as a strategy of money management for the forex market. I see two main drawbacks of this system.
The first drawback is the need for a large ratio of the base rate to the total deposit size. In addition, it is very difficult to calculate exactly what stock you need. Even if you study the example of roulette, how many losses in a row do you put in order to calculate the margin?
For 6 deals, the size of the amount of bet has reached $320, during the seventh deal it will be $640, and during the eighth one it will be more than a thousand. This means that for eight losses in a row, the amount of bet will grow more than 100 times (to be more precise, 128 times).
A reasonable question arises: how realistic is the scenario, when you do not guess the result, 5, 8, 10 times in a row?
There is hardly anyone who can give a clear answer to this question. One of the most accurate ways to guess what margin you need is to test the strategy in real-world conditions.
The second disadvantage follows the first one and it lies in the fact that working according to the principle of doubling rates, at certain point the situation can get out of control, and the trader (the player) can lose huge amount of funds. In other words, it’s difficult to stop on time.
If a player loses 5, 8, 10 times in a row, he has only one thought in his head: next time I should win. He will perceive a long series of losers as an anomaly which will definitely be over in the next round. At this moment the rate amount is very high, and the player runs out of money. Even if the other parameters of the strategy are ideal, if in the end the trader cannot stop and he is not able to make rational decisions, failure is inevitable.
The third disadvantage directly concerns financial markets and the Forex market in particular. The problem is that, in contrast to the roulette in casinos, financial markets are not linear. If in the first case you have 3 possible outcomes (red, black and zero), you can easily calculate the probability of one outcome or another, and the winning amount is fixed at each outcome. This is not the case with trading. The winnings are not fixed; if the price goes your way, you can complete the transaction, when the price passes 20 points, or you can wait and pick up 100 points.
The outcome of the transaction is not linear. For example, the price can go 20 points one way, go back to 10 points, then pass 30 points more without stopping and stay at one place for several hours.
Spreads, commissions and swaps make small adjustments to yield. In different strategies, brokerage costs have a different effect on the trader’s yield, but the presence of spreads and swaps still distinguishes trading from the roulette.
If you want to try the Martingale system in its pure form for trading, do it in binary options, where conditions are very close to roulette:
- Fixed payouts
- Two possible outcomes
Write in the comments what you think about this approach and what conclusions have made for yourself.
AVERAGING IN FOREX
If Martingale method belongs to the strategies of money management, then averaging is a risk management tool. To begin with, you need to understand the concept of the average transaction opening price.
Let’s suppose that you have opened a long position in the EUR/USD currency pair at a price of 1.5000. In this case, the average opening price of the transaction will be 1.5000.
Another example: you opened a long position at a price of 1.5000, and after a slight movement of the price down, you opened another long position at the level of 1.4950.
To determine the average price, it’s enough to use the simplest formula as follows:
(Quotation 1 + Quotation 2) / 2
So, the average price for current open positions on EUR/USD is (1.5000 + 1.4950) / 2 = 1.4975 points.
Technically, averaging is carried out in the following way on the Forex market:
- You are taking a position.
- The price goes against your expectations.
- Within a certain price range, you take new trading positions of the same direction (an example will be given later).
- When the price goes in your direction, you should gradually make profitable trades, and by the time the price returns to the starting level, the very first trade, you already have a profit for the rest of the trades.
A little bit later, we will discuss how to start trades “against the market” and when they should be completed.
WHY IS IT NECESSARY TO KNOW THE AVERAGE PRICE?
A trader should know the average transaction price in order to understand the level at which the breakeven point comes, that is, when the trading position climbs into the positive territory.
When we take one long position at a price of 1.5000, without any calculations we know that if we find the rate below 1.5000 we will have a floating loss, and if the rate is above 1.5000 we will have the floating profit. But if we take a long position at 1.5000, we will take a few more of them at the following levels: 1.4975, 1.4950, 1.4925 and 1.4900, we will be able to calculate that the breakeven point is at the following level:
(1.5000 + 1.4975 + 1.4950 + 1.4925 + 1.4900) / 5 = 1.4950
Thus, regardless of when the price will return to the mark of 1.4950 and will go higher, the position will become profitable. At 1.5000 mark, where we opened the very first deal, we will already have a tangible profit.
IN WHAT CIRCUMSTANCES DO TRADERS AVERAGE THE POSITION?
Judging from my experience, traders average the positions in several cases.
TO GET THE POSITION WITH SMALL VOLUMES AND THE BEST AVERAGE PRICE
Let’s imagine a trading strategy with the following characteristics:
- You are making medium-term trades and are going to hold a trading position for at least a few weeks;
- you are going to earn at least a few hundred points on the next move; and
- the average amount of your position is 1 lot;
At the moment, the price is in the price range (flat). The distance between the upper and lower boundaries of the range is approximately 50 points. Current price of EUR/USD = 1.5000 points. You can take a long position in at least three ways:
Method 1: to open a deal with the volume of 1 lot at a market price. This means that right now you will open 1 trade with your standard trading volume at a price of 1.5000. The average position price will be equal to the opening price.
Method 2: set a pending Buy Limit order to open a long position. We put a pending order for EUR/USD purchasing at a price of 1.4950 with the volume of 1 lot. When opening an order, the average price will be equal to the opening price, that is, 1.4950.
However, the trader faces the risk that the uptrend will start without bouncing off to 1.4950. In this case, the trade will not be opened, and the trader will be forced to either catch the last train, opening the position at a less favorable price, for example, at 1.5050, or stay out of the market entirely.
Method 3: Gradually open the position. To do this, we will divide our standard trading volume by 5 parts.
1 lot / 5 = 0.2 lots
For what it’s worth, I specify that in this case it is possible to come up with the completely different variants, one of which is realized via the Martingale approach. In this case, the first trade can be opened at 0.1 lots, the second one can be opened at 0.2, the third one at 0.4, and the next one at 0.8. You can also collect the position by any number of trades. For example, I allocated a position for 5 transactions at 0.2 lots, but it would have been possible, for example, to open 2 deals with the volume of 0.5, or open the first one at 0.3, and the second one at 0.7.
Let’s suppose that you distribute the trading volume in equal parts between all the positions and place the pending orders at a distance of 20 points. As a result, we get the following order list:
- Buy Limit — 0.2 lots — 1.4980
- Buy Limit — 0.2 lots — 1.4960
- Buy Limit — 0.2 lots — 1.4940
- Buy Limit — 0.2 lots — 1.4920
- Buy Limit — 0.2 lots — 1.4900
Thus, the average opening price will be:
(1.4980 + 1.4960 + 1.4940 + 1.4920 + 1.4900) / 5 = 1.4940
If a trader opens a trade with pending threshold orders, he gets a more favorable opening price, but at the same time faces the risk that he will not be able to open the position before the main move toward Take Profit starts. Collecting a position is possible not only by thresholds, but also by stop orders. This means that the trader adds a trading volume as the price moves to the direction he needs. This technique is mainly used by those traders who take the positions for very large amounts (for the funds and big investors) on stock markets. The reason why they do it is that they simply cannot buy the volume of shares or futures that is required on the market. I will explain it a little bit more in detail.
Let´s suppose that you want to buy shares of a small French company for a million dollars. In the Depth of Market you will see the number of sales applications that are available at the moment.
Let´s suppose that the current stock price is $20. Seeing the pending applications for the sale of shares, you understand that for $21 you can buy 100 shares, for $22 another 200, and so on.
If you try to buy on the market for a million dollars, you will instantly buy out the entire volume for sale at quite a large price range. In the end, if you buy the first stocks for $20, the last purchases can be already for $60, and the average price can be 2-3 times higher than the initial price.
This is an exaggerated example, but a similar situation on the stock exchange is solved by a certain mechanism. I hope you have understood the main point that big players cannot successfully take a big position with one transaction, therefore, they have to collect it gradually. In this case, the mastery of the trader lies in getting the most profitable average entry price.
Let’s talk about the other reasons why a trader can average his position.
IN ORDER TO MAKE MORE
Experience shows that, among the forex traders, there is the pursuit of additional earnings which is the main reason for averaging the transactions. The following example illustrates what exactly happens in this case:
- Trader believes that the EUR/USD price will rise and he opens a long position to buy EUR/USD at a price of 1.5000
- The price goes against the expectations of the trader
- The trader is still confident that the price will rise, and at the price of 1.4950 opens another long position.
- The same thing happens several times on 1.4926, 1.4912 and 1.4900 levels.
If the volume of transactions was the same in all positions, the average exit price is the following:
(1.5000 + 1.4950 + 1.4926 + 1.4912 + 1.4900) / 5 = 1.4937.6 points.
If the price returns to this quote, the trading position will be at breakeven level. If the trader was originally right and EUR/USD will go above 1.5000, the profit will be significantly higher than the one that was initially planned.
Unfortunately, in practice, such trades lead to the loss of the entire trade deposit (they are forcefully closed by Stop Out), when free funds for securing the open positions are running out on the account. In my opinion, this happens due to the following reasons:
- The trader does not initially have a plan describing at what levels he will add a trading volume;
- When averaging, the trader is driven by greed rather than rational calculation;
The trader does not have a plan B, in the unfavorable situation, he will not be able to terminate the unprofitable positions, but will go on averaging with the hope that the price will break out.
That is why both averaging and the Martingale system are considered to be the killers of trade deposits.
Running ahead of the story, I will express my position regarding this statement. I think that the listed instruments can be a strong weapon in the hands of a professional but, for the beginners, such strategies are not suitable.
The main reason for a deposit’s drain is the emotion and the inability to follow the planned strategy. I would be glad if my readers could make a sober estimate of whether they are able to close a loss position in averaging on time. If not, then at this stage it is not worth using such an approach on the real account.
THE TRADING STRATEGY BASED ON MARTINGALE AND AVERAGING STRATEGIES
By combining the Martingale method and averaging, we get a ready-made trading strategy with the following rules.
- We need to have a high ratio of standard trading volume and the deposit volume.
For example, with a trading volume of 0.1 lot, you can have a deposit of $1,000 or more. These numbers are an example and not a recommendation; you have to think for yourself what deposit size will be acceptable.
- From the trading instrument chart (or from the indicators), we must understand that in the medium term there is a sideways trend (flat). In other words, at the moment there is no clearly directed up or down trend. Under such conditions, the price is unlikely to go so far in one direction that the trader’s money is over.
- We need to have a clear rule according to which we open new positions. I can offer the following basic options:
- We need to have a high ratio of standard trading volume and the deposit volume.
- To exit pending threshold orders in each specific price range, for example: every other 50 points.
- To open the position at each new support (or resistance) level.
For example, if you analyze the market with the help of the Price Action method, you can average when the price breaks down the horizontal level. If you are the follower of candlestick analysis, you can open a new position after certain candlestick combinations.
- Each next position opens in volume that is two times bigger than the volume of the previous one (the Martingale Principle). In fact, even without this point, the strategy will remain operational, but you will reduce both the potential risk of loss of the deposit and the potential profit on trades.
- It is necessary to have a clear rule for closing positions. I suggest the following options:
- Close the position at the breakeven point. You need to do it if your view of the market has changed and you no longer expect a further increase of prices (according to our example). In this case, the reverse order (which will serve as a take profit) is put one point above the breakeven point so that the position closes with a profit of 1 point. This is a purely psychological aspect; I will not focus on this now. In general, there is no big difference whether you complete the transaction at zero, or with a profit of 1 or 2 points. In fact, you stayed with your initial capital having gained the experience of another trade. According to all the parameters, such a trade can be considered successful.
- Close each trade transaction on the level of opening of the previous one. This scheme resembles the domino principle. Let’s return to one of our examples where we opened the following long positions:
Buy Limit — 0.2 lots — 1.4980
Buy Limit — 0.2 lots — 1.4960
Buy Limit — 0.2 lots — 1.4940
Buy Limit — 0.2 lots — 1.4920
Buy Limit — 0.2 lots — 1.4900
So, we have opened the last deal at a price of 1.4900, at the moment the price is at the level of 1.4888.
We will complete the transaction in the following order.
We will open the last transaction at the opening price of the previous one. That is, at the level of 1.4920.
The trade, which was opened at the price of 1.4920, is closed at 1.4940
The trade, which was opened at the price of 1.4940, is closed at 1.4960
The trade, which was opened at the price of 1.4960, is closed at 1.4980
The trade, which was opened at the price of 1.4980, is closed at 1.5000
As a result, we have one (the very first) trading position, and we have to decide what to do with it. In addition, we have already fixed 100 profit points in my pocket which, in my opinion, is an excellent result.
Important! Let me draw your attention to one technical point.
In the MetaTrader platform, you cannot put a single stop loss for all the open positions. Stop loss can be set for the particular trade. Thus, to close several positions at the same time, you need to create an opposite pending order the volume of which is equal in relation to the total volume of open positions that you are going to close. For example, if you want to place a pending order to close three long positions, each of which has a volume of 0.2, we must issue a Sell Limit order at a price above 1.4940 with a volume of 0.6 lots.
If any calculations are not clear, please write in the comments, I will explain them in more detail.
- Close all open positions at the same time.
If we once again return to our example, having 6 open positions, we set the total take profit at a price above 1.5000. This method presupposes the maximum profit, since if in the previous case after closing 5 deals we had a balance of +100 points, in this case we will have the following:
(1.5000 — 1.4980) + (1.5000 — 1.4940) + (1.5000 — 1.4920) + (1.5000 — 1.4900) = 20 + 40 + 60 + 80 + 100 = 300 points of floating profit, not taking into account the very first deal with its opening at a price of 1.5000. If we close the deal when the first position also has the profit of 20 points, the profit will be not 300, but 420 points (count it yourself and write in the comments if you got the same number).
With 6 open deals, when the price is returned to a level of above 1.5000, the cost of each item will be 6 times bigger than at the moment of opening the first trade.
WHAT METHOD DO I PREFER?
Choosing between the second and third way, I prefer the second one. Yes, with a lucky coincidence, the third method is most profitable. But the second one has another significant advantage that I did not mention earlier. Imagine the following scenario:
You have the same 6 deals opened, and after opening of the sixth one the price returned to the level of 1.4950. Have we considered the example when the price goes up and returns to 1.5000? And what happens if it goes down again? Let’s list the possible outcomes:
- If you have not closed the part of the transactions, their floating profit will become a floating loss, you will have to hope for a price rebound.
- If you have closed some of the deals with profit, you have the following choice:
- To do nothing waiting for the price to return to 1.5000 with a floating loss for the 3 remaining transactions;
- To record the loss of the remaining three transactions, as a result, for all the 6 positions you will be in a small minus, but if the price goes down further, you will save the trade deposit.
- To set the buy limit of the order again.
In this case, repeat the original scenario according to which you opened 6 transactions. Long positions will be open again at the levels of 1.4940, 1.4920, and 1.4900. After their opening, again you have to decide when to take the profit or loss for these positions.
Taking into account all the pros and cons, in most cases I prefer the strategy according to which each next transaction is completed at the opening price of the previous one. In other words, I choose a less profitable but less risky way. I understand that this part of the lesson can be quite difficult for a beginner to understand. It is very important for me to know your opinion, how clear everything that I wrote was, so I am really looking forward to your comments at the end of the lesson. I read all the comments on the articles attentively, and make a point to expand on the aspects that were not clear enough to someone.
LOCKING OF THE POSITIONS ON FOREX AND LEAVING THE LOCK
I suggest analyzing this tool closely as it is actually rarely used by traders, although it has a great potential for application.
In simple words, locking is a strategy when you apply a pending order instead of stop loss to open an opposite position with the same volume.
Here is an example.
We opened a long position in the EUR/USD currency pair at a price of 1.5000 with the volume of 1 lot. For comparison, the following variant is available for fixing loss in case if the price goes against your expectations.
- Put a stop loss order at the level of 1.4950. In this case, you will fix a loss of 50 points.
- To put a Sell Stop order with a volume of 1 lot at 1.4950 level.
Let’s describe the situation that will occur at the time of opening this order.
You will have 2 open multi-directional trading positions of the same volume: a long open position with a price of 1.5000 and a short open one with the price of 1.4950.
The floating loss will be 50 points (1.5000 minus 1.4950). If the price changes in any direction, the floating loss will not change. If the price increases by one point, the loss on a long position is reduced by one point, and the loss on a short position increases by one point. If the price falls by one point, the opposite will happen.
HOW TO EXIT FROM THE LOCK?
This is a key question for which there is no perfectly correct answer. In my opinion, you need to rely on your trading strategy. The first thing is to analyze why you opened a long position and why the price did not go in the right direction.
The most correct continuation seems to be the search for a point in which, according to your strategy, the price should change the direction and go up. This can happen either after the corresponding indicator signal, or the reversal candlestick model, or the formation of a new level of support and a rebound from it.
When the pivot point appears, we fix the profit (in our example, for a short position), and wait until the price returns to the point of opening the first (long) transaction.
With a good combination of circumstances, you do not lose money on the stop loss, as it was in the first scenario, but also get a profit from a lucrative short transaction.
The reverse side of locking
Of course, it is possible to leave the lock incorrectly, and then you will get a loss on both positions. The scenario in which this may happen is as follows:
- You open a long position on EUR/USD at a price of 1.5000;
- You put the lock (sell stop order with the same volume) at the level of 1.4950;
- The price reaches 1.4950 and opens your lock;
- After that, the price returns and it is fixed at the level of 1.5020;
- You still believe that by all the indications the price will rise further. You do not want to fix profits on a long position (it´s too early), and the floating loss on a short one will increase if the price goes up further;
- You close a short position fixing a loss of 70 points;
- After closing a short deal, the price goes back down again, and now you already have a floating loss on a long position;
In this situation, the trader has three possible outcomes:
- A trader waits until the price starts to rise, and a long trading position can be closed with the profit;
- A long position closes on the stop loss if the trader puts it;
- The trader loses the deposit if he does not put a stop loss.
I invite you to think about it yourself and write in the comments about what conclusions you arrive at.
On this note I suggest finishing the lesson about the Martingale strategy and locking. I hope you enjoyed it. To remember the material better, I will give the key ideas of this lesson.
SUMMARY OF THE LESSON
- Martingale strategy and averaging may improve the trading system’s indicators, but they are quite dangerous for beginners.
- To use Martingale, it is necessary to have a good ratio of the standard trading volume to the size of free funds on the trading account.
- To re-deposit money to the account at a large floating loss on the trading account is extremely dangerous!
- The main reason for the loss is not a trading strategy, neither averaging, nor Martingale, but a mental instability.
- The key difficulty of averaging is to close the unprofitable position.
- Locking may be more effective than Stop Loss if the enter and exit strategy is correct, tried and tested.