The Martingale System: The Roulette Strategy That Transfers to Investment

Betting systems are used to add structure and negate losses. The Martingale strategy is a popular one, which has also been used by many traders to great effect. Yet it can also produce huge losses, so it must be tackled carefully.

The Martingale System in Roulette

The Martingale system for betting originated in 18th-century France, just as the concept of the roulette wheel was becoming popular. Since then, it has become one of the foremost strategies for managing a bankroll and minimising losses.

For it to work, it has to be in games where the outcome is either a win or a loss. A gambler must choose a unit with which to bet, say, for example $10. Whenever they have a loss, this then doubles. So their next bet would be $20. If this is another loss, then the bet doubles again to $40. This continues until the person making the wager reclaims their initial loss and wins, at which point they go back to their base unit to bet on.

This helps to limit the losses a gambler can make. In fact, they can not lose if there is no limit on the size of bets and they have infinite wealth to gamble. Very few people have this, however, and as a result, the Martingale can be risky. Losing totals can quickly add up, depleting a bankroll and leading to large losses.

Anyone using this should know the game they are playing. In American roulette, the house edge is increased due to the inclusion of two zeros. Thus, the game is not strictly a 50/50 outcome, with the house edge rising to 5.26%. This can also have an impact on the strategy, as can rule variation in European and French roulette.  

Using the Strategy for Investing

When using the strategy for investing, it also takes some nerve. It still works on the fact that you can not lose all of the time, and involves a similar concept. When a stock decreases in value, you double the amount invested and keep on going. The idea is that at some point they will go up and you will make the gain back. The problem is that not all businesses do this.

It also comes unstuck because most exchanges will have a cap on how much you can invest. Thus, if you keep losing, at some point, you won't be able to increase the amount you are investing. Also, unlike roulette, trades have transaction costs and fees, which can be quite high. These will keep on increasing as the size of the trades goes up.

Finally, businesses that go bust may stop trading. All of this would be a catastrophic loss of capital.

Assessing Mean Reversion

At its heart is the idea of mean reversion. It is the concept that any asset price will converge at an average over time, and it is just a case of buying it at the right point. Flip a coin and you may get heads, two, four, eight, or sixteen times in a row. However, flip it a hundred times and you would expect a 50/50 average. It is the same idea.

Many people use mean reversion to pinpoint exactly when to buy a stock. They will generally see stocks that have fallen from the average as ones that will go up in price, and ones that are above this will be expected to go down.

There are some quite famous and successful investors who have used mean reversion to great effect. Warren Buffett is famous for this, as he once said, "Be fearful when others are greedy and greedy when others are fearful". This meant that when prices are down, it is the best time to buy, as at some point they will tend to move toward an average. Bill Miller, Peter Lynch and Kenneth Fisher are also investors who have used this concept.

The opposite is the anti-Martingle strategy. This involves increasing trade sizes during a winning streak. A bigger risk is taken during periods of expansive growth, with traders buying as prices rise and increasing to buy in larger amounts until all assets are exhausted.

Any loss is generally believed to be negated by the capital already accrued. This works as a stop loss, cutting any losing trades in half. However, it also has its drawbacks, as all upward trends eventually come to an end, and markets can pivot suddenly.

The Martingale carries a very high level of risk. It really needs a lot of capital to ensure security, and even this is not guaranteed. Many people fall for the gambler's fallacy, that one event must have a bearing on the next. Use it only alongside informed research and strategies to ensure safety and success.