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Labouchere (Cancellation) System in Trading

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Written By
Dan Buckley
Contributor Image
Written By
Dan Buckley
Dan Buckley is an US-based trader, consultant, and part-time writer with a background in macroeconomics and mathematical finance. He trades and writes about a variety of asset classes, including equities, fixed income, commodities, currencies, and interest rates. As a writer, his goal is to explain trading and finance concepts in levels of detail that could appeal to a range of audiences, from novice traders to those with more experienced backgrounds.
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Updated
Aug 22, 2024

The Labouchere System – also known as the Cancellation System or Split Martingale – is a betting strategy used in trading.

Developed by Henry Labouchere, a British aristocrat and politician in the 19th century, this system was initially designed for roulette but has since been adapted for various forms of trading and other betting games.

 

Key Takeaways – Labouchere (Cancellation) System in Trading

  • Goal-oriented strategy
    • The system provides a clear profit target and structured approach to position sizing.
    • Potentially helps traders maintain discipline and avoid emotional decision-making.
  • Escalating risk
    • Losing streaks can lead to rapidly increasing bet sizes, quickly depleting a trader’s capital.
  • Limited application
    • Best suited for binary outcome trades rather than continuous profit/loss scenarios.
    • Traders should thoroughly test the system in a risk-free environment over a long enough time horizon before using real money.
    • Like many aspects of trading, it’s a matter of optimization of all the components (e.g., asset allocation, hedging/position sizing/risk management), not magic systems.

 

Origins and Purpose

The Labouchere System was created with the aim of recovering losses and generating a profit equal to the sum of the numbers in the initial sequence.

Unlike some other betting systems, the Labouchere method doesn’t require an infinite bankroll or the absence of maximum trade size restrictions to theoretically succeed.

 

How the Labouchere System Works

The Labouchere System involves a sequence of numbers that determines the size of each bet.

The goal is to cross off all the numbers in the sequence, at which point the player or trader will have achieved their desired profit.

Setting Up the Sequence

  1. Choose a target profit amount.
  2. Break this amount into a sequence of smaller numbers that sum up to the target.
  3. The sequence can be of any length and composition, as long as it adds up to the desired profit.

For example, if looking for a profit of 10 units, a possible sequence could be: 1-2-3-4

Placing Bets

  1. The bet size is determined by adding the first and last numbers in the sequence.
  2. If the bet wins, cross out these two numbers.
  3. If the bet loses, add the bet amount to the end of the sequence.
  4. Continue until all numbers are crossed out or you decide to stop.

 

Examples of the Labouchere (Cancellation) System

These examples illustrate how the sequence changes with wins and losses, and how the bet sizes can increase after consecutive losses.

Example #1

Let’s use the sequence 1-2-3-4:

First bet: 1 + 4 = 5 units

  • If win: Cross out 1 and 4, leaving 2-3
  • If lose: Add 5 to the end, making it 1-2-3-4-5

Next bet (assuming a win):

  • 2 + 3 = 5 units
  • If this bet wins, all numbers are crossed out, and the session ends with a profit

 

Example #2: Longer Sequence

Now let’s use the sequence 1-2-2-3-3-4:

First bet: 1 + 4 = 5 units

  • If win: Cross out 1 and 4, leaving 2-2-3-3
  • If lose: Add 5 to the end, making it 1-2-2-3-3-4-5

Next bet (assuming a win):

  • 2 + 3 = 5 units
  • If win: Cross out 2 and 3, leaving 2-3
  • If lose: Add 5 to the end, making it 2-2-3-3-5

Next bet (assuming another win):

  • 2 + 3 = 5 units
  • If this bet wins, all numbers are crossed out, and the session ends with a profit

 

Example #3: With Losses

The sequence is 1-3-2-4:

First bet: 1 + 4 = 5 units

  • If win: Cross out 1 and 4, leaving 3-2
  • If lose: Add 5 to the end, making it 1-3-2-4-5

Next bet (assuming a loss):

  • 1 + 5 = 6 units
  • Lose again: Add 6 to the end, making it 1-3-2-4-5-6

Next bet:

  • 1 + 6 = 7 units
  • If win: Cross out 1 and 6, leaving 3-2-4-5
  • If lose: Add 7 to the end, making it 1-3-2-4-5-6-7

Next bet (assuming a win):

  • 3 + 5 = 8 units
  • If win: Cross out 3 and 5, leaving 2-4
  • If lose: Add 8 to the end, making it 1-3-2-4-5-6-7-8

 

Advantages of the Labouchere System

Flexibility

Users can adjust the initial sequence to suit their risk tolerance and profit goals.

  • Longer sequences with smaller numbers tend to be less risky but take longer to complete
  • Shorter sequences with larger numbers are riskier but potentially quicker to resolve

Goal-Oriented Approach

The system provides a clear target for each session.

Potential for Profit in Winning Streaks

During winning streaks, the Labouchere System can generate profits relatively quickly as numbers are crossed off the sequence.

 

Disadvantages and Risks

Increasing Bet Sizes

As with many progressive betting systems, losing streaks can lead to rapidly increasing bet sizes.

This can quickly deplete a trader’s asset base or hit limits in certain scenarios – e.g., maximum bet size for binary options.

False Sense of Security

The system can create a false sense of security, as it appears to “recover” losses by increasing bet sizes.

However, this doesn’t change the underlying odds of each individual bet.

Complexity in Application

Compared to simpler betting systems, the Labouchere method requires more record-keeping.

Narrow Application

Best suited for games or instruments with binary outcomes rather than continuous P/L.

 

Modifications and Variations

Traders (and those who apply it to other betting games) have developed various modifications to the original Labouchere System to address some of its weaknesses or adapt it to specific scenarios.

Reverse Labouchere

In this variation, numbers are added to the sequence after wins and removed after losses.

This approach tries to take advantage of winning streaks while limiting losses.

Johnson Progression

This modification involves using a fixed sequence and adjusting bet sizes based on the outcome of previous bets, rather than crossing out numbers.

 

Conclusion

The Labouchere System offers a structured approach to betting and trading that can be appealing to those seeking a goal-oriented method.

But, like all betting systems, it doesn’t change the underlying odds or guarantee profits.

Traders should approach this system with caution. Fully understand its risks and limitations.

When applied to trading, the Labouchere System should be used in conjunction with quality market analysis, risk management techniques, and a well-defined trading strategy and plan.

It’s important for traders to thoroughly test the system in a risk-free environment before applying it to real-money trades.