Death by Doubling Down

The gambling system, which dates back to a London gaming house in the late 1700s, is completely irrational, yet incredibly seductive. The thinking: If you keep doubling your losing bets, eventually a winning trade will make up for the losses. Like making a deal with the devil, the Martingale system will always comes back to haunt you — and often more quickly than you might expect. (For a more detailed history of the Martingale, I'd recommend Nicholas Dunbar's wonderful book, "Inventing Money.")

Unlike Jim Cramer or Arch Crawford, I don't give out a list of stock picks each week. My philosophy is that trading technique, not security selection, is what ultimately determines success. We of the Tradecraft prefer not to give a man a fish so that he may eat for a day, but to teach a man to fish so that he may eat everyday.

So instead of a list of this week's "hot stocks," I'll give you a piece of advice you can use for the rest of your life: Don't use the Martingale. It simply doesn't work.

Sure, you might win once in a while with the Martingale — perhaps enough to keep you interested in the strategy. But eventually, you'll lose it all, in a very quick and undignified fashion. Take it from somebody who has tried it — the Martingale will kill you. It has to kill you. Why? The strategy is inherently flawed. It's designed to have you increase your bet at exactly the wrong time.

The smartest thing an investor can do is trade with the trend. The Martingale forces investors to be antitrend, fighting the market rather than following it. That's a recipe for failure.

While each roll of the casino dice is an independent event, stock prices have a tendency to follow a trend. As we've pointed out from the beginning, a trade can't be good for the "long haul" without first being good for the "short haul" as well.

But the Martingale forces you to trade against the trend, which in my book stacks the deck against you from the start. And although moving with the market is a lot more difficult than doubling down, a pro-trend strategy works over time because it will inherently focus you on the most promising, high-probability ideas.

While good traders never know exactly how the market might move, they're always aware of the relative risk of their positions. That's another major problem with the Martingale system: It prompts you to increase your position size at exactly the wrong time.

As we often point out, trading isn't about avoiding risk, but managing it. And when your account shrinks, prudence dictates your position size must shrink as well. Yet the Martingale system has you increasing your bets with every losing trade. It is exactly the wrong move.

The reality of using the Martingale is that you'll often lose several bets in a row, leaving you without the cash — or the nerve — to double on the next bet. Even for the biggest of bank accounts, that's a sucker's trade you should avoid making.

A final flaw with the Martingale is that it offers limited profits. Very limited profits. Because the system mandates you sell every position at the first sign of a profit, you are, in effect, cutting your winners and letting your losers run.

The point of trading isn't to make trades all day, but to get into good positions and ride them out. The notion of a lot of small winning trades may be appealing, but the real gravy is made on catching a big trend and sticking with it for as long as possible.

The Martingale is a trading style that's designed for failure. So stop searching for stock tips and start focusing on technique. No matter how skilled a stock picker you think you may be, what you buy will never be as important as how you buy it.

Jonathan Hoenig is portfolio manager at Capitalistpig Asset Management, a Chicago-based hedge fund.