Risk mitigation that might make Martingale viable?

Warning: I'm a newbie and haven't started live trading yet, so I might be talking complete ballcocks.

Background: Over the last few weeks/months I've been working full time on reading and learning (with the odd paper trading to get the feel of things). I've read tens of thousands of posts on FF alone, not to count articles, blog posts, books etc., elsewhere. I am aware of previous discussions here on martingale and some strong feelings on the subject. And I agree with them. I appreciate the nature of the finite funds available to us and that the market can stay irrational for longer than ... well, you know the drill.

So I've been thinking about how risk can be mitigated. In currency pairs there's no theoretical limit to which a currency can rise/fall. This obviously has downsides to using martingale as a currency pair can form a slow and steady move upwards/downwards with no reversals (unlikely, but not impossible).

However, some securities do have limits or virtual limits (and 0.00 is a limit for a currency pair on the short side). I've been looking at a few of these tradeable securities. But let's take indices as an example. The FTSE100 is trading at under 6000 after reaching a high (five years ago) of about 6700. Theoretically, it's unlikely to pass 7000 in the near future (though it's not impossible, but we'll come to that). Assuming you went short on the FTSE using martingale, you have an artificial barrier that the FTSE can't exceed if it goes against you. This known barrier also makes it easier to plan the position size given you know the available funds in your account.

To hedge against the worst case scenario of a 7000+ price one could take an option. A hedge against 7000 has got to be quite cheap in today's market.

The only risk that then remains is that the FTSE could go against us a long way (no pun intended) and stagnate. But such level of stagnation has never happened in the history of the index. To be on the safe side perhaps one could take a volatility hedge as well to protect against volatility dropping to near zero.

Where's the flaw in my logic? There's got to one there somewhere surely?

The scale, I think. Divide the space between the current price and the "theoretical limit" into martingale steps so that you wouldn't be wiped out until the price actually reaches that limit. I'm fairly sure you'll end up either with too small bets or with too large steps. Most likely both.

Wide,

Assuming that I understand correctly, what you're effectively describing is betting both for and against the same instrument, on different markets. I don't know enough about options to provide a mathematical answer your question, but I'd be surprised if an arbitrage opportunity exists for the simple reason that if one did, it would be more widely known and exploited.

If arbitrage is not possible, then one big problem that I personally have with grids, martingales, etc is highlighted by the language in your post: "unlikely, but not impossible"; "virtual limits"; "has never happened in the history of the index"; ........ you know what I mean

Hence it follows that, in sizing your bet(s), it's ultimately a case of working out:

 

1. exactly what the worst case scenario would be;
2. your maximum loss if this scenario was to occur;
3. what effect that loss would have on your family's finances/lifestyle, and whether that is acceptable to you;
4. your assessment of the probability of the scenario occurring (not necessarily an easy task!); and
5. having considered all of the above, whether you are personally willing to take the risk.

Good luck.

Just stating the obvious.

David

Hanover, my old friend, thanks for joining the thread.

OK, you're not an old friend, but I've read sooo many of your posts, particularly on martingale, that I feel I know you well. Pardon the familiarity.

Perhaps I'm naive but to me the fact that a technique/opportunity isn't being exploited isn't irrefutable proof that it doesn't exist.


I think you misunderstand. These very low probability events aren't being discounted. On the contrary, my suggestion was to hedge against them. The very fact that they are so unlikely makes the hedge cheap. You then have an event horizon you don't need to worry about.

That's the event horizon and it has already been insured against.

Break even is what I'm hoping to achieve in this scenario.

I appreciate the friendly advice but I've got this bit figured out. I'm learning and absorbing and theorising and experimenting. That will be followed in due course by paper trading and then real life with small trade sizes. I have a decent five figure sum I can afford to lose but which I have no intention of losing hence all the questions first and all the trading later. In due course I'll be a "full time" and successful trader. I have zero doubt about it. I have the ability, the discipline, the patience and the time to acquire the skills though I appreciate it's a life long learning experience.

Back to the martingale with a hedge against a pre-decided low probability worst case scenario to reduce the trading space.

Thanks Barbosa, you're spot on. That's where I'm hitting some problems but I think I can get around them. I'm playing with some spreadsheets at present. It appears that I'll have to create two hedges - one against the event horizon and one will be a volatility hedge against a situation where the price goes close to event horizon and stagnates there. The time component of options is a fly in the ointment I'm aware of but ignoring for the moment (but only till I can get the rest worked out).

Agree 100%.

Sure. Either it's possible to attain an arbitrage situation by hedging the risk created by the martingale, or it's not. If you can reach the point where return is guaranteed with zero risk, then you're home free.

Agreed, the risk you're seeking to hedge is tiny in terms of probability, but if you've been doubling up extensively along the way, then I suspect that the amount of the potential loss that you must hedge yourself against, may be extremely large. That's (obviously) caused by the very nature of martingale.

I wish you every success.

Not really a flaw, but not really much of an opportunity either. Martingale is confusing the issue - you're not mitigating the risk of martingale, you're simply mitigating directional risk above 7000 across a certain time period. The option will have to be valued at your full martingale progression, so it'll be several factors more expensive that if you were not martingaling. But position sizing is not relevant to the equation, and all you're doing is swapping one risk for another (time & vol).
Using puts/calls as stops is perfectly viable alternative to placing stop orders on spot, but it's no golden goose that's for sure.
Personally, if i was adamant of a fall from here using options, I'd go all in here with an ATM call and short spot. horses for courses

Excellent food for thought. Thanks Hanover and triphop for your wise replies.

I agree with both of you in your analysis of the hedge needing to cover the full martingale progression. If I didn't cover the full value from the start and instead I increase the hedge position in stages by buying more options later - based on how the short position was faring - there would be the inevitable rise in the cost of the options to be taken into account. Not good.

Of course using an ATM call as a SL is a viable protection but this would still involve covering the full martingale progression right at the start and an ATM would be far more expensive to buy.

The feedback in this thread has given me an idea or two and suggested a change of tactic. I'll mull it over and play around with some spreadsheets. I'm very grateful for your inputs.