The Martingale betting system is one of the oldest betting systems in the gambling world.
It is based on the biggest gambling myth that an event that has not happened recently is way overdue and about to happen. It is also called “gamblers” fallacy. The system was originally developed in the casino game called roulette, where there is an equal chance of winning.
To understand the system in simple way let us take the example of coin toss. In the coin toss there is 50-50 chance of winning. Lets’ say a gambler puts $5 on coin toss and bet on “head”. If the outcome is “head” he wins $5 and if it is “tail” he loses $5.
In the martingale system the gambler doubles his bet every time he loses. So lets’ assume he lost $5 on coin toss so his next bet would be $10. If he loses again then he would bet $20, and if he loses again he will bet $40 and so on. The assumption is that soon he will win and recover all his previous losses. Instead he loses all his money.
This is recipe for disaster as it is based on the gambler’s fallacy that past event will affect outcome of future events in case of random events.
Even if a gambler has unlimited amount on hand he can still lose big as casinos put a “table limit”, this means a gambler cannot just keep betting and doubling his amount on each bet.
The same concept can be applied in options trading. Let’s say an option trader is bullish on AAPL and buys 10 contract each worth $200. Thus he invests $2000. Let’s assume, AAPL, instead of moving up moves down and therefore, his AAPL calls are now trading at $100 per contract. Thus his investment is reduced to $1000 on books. Instead of closing the position and taking loss of $1000 the same trader now invests $4000 thus buying 4o more AAPL contracts at $100 per contract. Now he has 50 contracts of AAPL. His total investment is now $6000.
Let’s say AAPL does not move and calls value decreases and trading at $50 per contract. Instead of taking loss, the same trader buys more AAPL contracts. This time he invests $8000. Thus he buys 160 contracts of AAPL. Now he has total investment of $14,000 (2000+4000+8000) and he holds 220 (10+50+160) contracts.
Let’s assume AAPL does not go up rather trades in a very narrow range. Due to time, the call values decline even further in value and eventually AAPL contracts expire worthless.
Similar to table limit in casinos, the Options Clearing Corporation (OCC) has “Position Limit” on such trades. This means in actuality, a trader cannot accumulate more than certain designated number of calls contracts in one stock.
This martingale strategy is therefore, need to be avoided. In reality, if a trader is a losing bet then he should reduce his exposure per trade and on his overall portfolio and should apply the concept of Risk and Position Sizing.
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