Is forextrading-zero-sum game?

Beginner Questions
22

Is Forex a zero-sum game? The confusion comes from the fact that Forex is a circular market. What I mean by that is:

Trader 1 enters a long at price X on pair Y. Trader 2 enters a short at price X on pair Y. For the sake of argument, they both enter their trades at the exact same time through the same broker, essentially trading against each other.

Price initially moves in favor of Trader 1. Trader 1 was only looking for a small move of 10 pips and he is able to close his position for a profit.

Trader 2, however, was looking for a much larger move to the downside. Price soon reverses 100 pips to the downside and Trader 2 also closes for a profit. Is this a zero sum game? No.

Thus far there has been no mention of brokers. The broker will extract the spread from each of these traders for profit, thus reducing, ever so slightly, the amount of capital actually in the market. If these two traders continue trading indefinitely and, using only their starting capital plus any gains, they will both eventually go broke (in the theoretical world) because there is a finite limit of money in the market that is being slowly reduced, trade by trade over time, by their own gains and also by their broker. All parties are now reducing the finite capital in the market, and their future profits will all be reduced by the percentage of their respective gains. Also, one must assume that there is a fixed amount of money in the markets to begin with. In this instance, yes, this is a zero-sum game.

The closest analogy I can draw is a Texas Hold ā€˜Em tournament. Eventually, there is a winner among the participants. The house (broker), however, always wins because of the entrance fee into the tournament (spread). Only one of the participants can win in the end because eventually there are no more chips available.

Now add the circular component. There are more than just Trader 1 and Trader 2 in the market. There is more than just one broker. There is always an influx of money into the market from others. The previous analogy no longer holds true. Instead of a Texas Hold ā€˜Em tournament you have ring game at a casino. The game continues indefinitely with the house (broker) extracting a profit from each pot (spread). Each player can stay at the table playing poker until, theoretically, they have a profit, get up and leave. Each player may leave the table with a profit as long as new players (and their money) enter the game.

This is almost exactly how forex works. Until either the entire worldā€™s supply of capital is exhausted or there are no new traders entering the market, each participant can, theoretically, win.

So, after a very long and drawn out post (sorry!), in theory, there are finite limits which make forex a zero-sum game. In practice, however, these limits will never be reached in our lifetimes so every trader can win without it being at the expense of the other traders in the market.

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Ya knowā€¦ I have to admit thatā€™s a damn good insight. Itā€™s only showing broker level, not account level. While I would say that youā€™re right in that it doesnā€™t disprove it, Iā€™ve yet to see a reliable article coming close to proving the ā€œ90% failā€ stat. Honestly, my take on the 90% number is that itā€™s a cop out by the ones who do fail to put blame somewhere other than where it should be. After all ā€œIf 90% of traders fail, how the hell could I be expected to win?ā€, and my inner cynic squeals in delight and would like to point out that I see a LOT of Americans parroting that line. America, land of the free, home of no personal responsibility. :slight_smile:

Note: Iā€™m an American, so thatā€™s not a harsh generalization based on an outsiderā€™s perspective, thatā€™s a personal observation. Itā€™s almost a cultural requirement to NOT accept blame.

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I agree completely. I have always considered the 90%, 95% or 99% of all traders lose money to be a big bucket of BS.

If you break the numbers down by account size, the larger the account the more likely the account is to be profitable. It would seem that new, inexperienced traders would open smaller accounts (stands to reason) and be more likely to lose money (also stands to reason). They still get counted in the stats simply because they have accounts. It doesnā€™t mean that every trader has a statistical disadvantage that cannot be overcome. It means that novices who havenā€™t figured out what they are doing are more likely to lose money with micro and mini accounts but they get counted along with the fewer number of traders that are ā€œrealā€ traders.

Those who know what they are doing naturally have larger accounts (whether they start off with them or grow them to that size doesnā€™t really matter). Not many novice traders are going to decide one day to trade and open a $50K account. They may open a $50 or $500 account maybe, but not $50,000.

The fact that fewer people (successful traders) with large accounts are in the market compared to the zillions of micro and mini accounts scews the numbers.

1 Like
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Amen to that! One other thing I take into account is the fact that I see a lot of people saying ā€œIā€™ve nuked quite a few accounts before I got to the point where I was profitable.ā€ Which would also tend to skew the numbers. After all, if I nuke 4 accounts before it sticks on the 5th try, Iā€™ve got an 80% fail rate. At that point it wouldnā€™t be hard to do a little logical jujitsu to get to ā€œwell yeah, I failed 80% of the time and everyone else I see does it, so 90% of traders fail!ā€

While I did come in to my first account with the Mythbusters moto of ā€œFailure is always an optionā€ firmly implanted in my brain, it didnā€™t mean I was going to accept it or go down without a hell of a fight. People just have the wrong mindset with the markets and I think thatā€™s a two-fold problem. 1, youā€™ve got hucksters out there selling the dream system of ā€œtrade 5 minutes a day and make 100,000 a month!ā€ and 2. Lack of understanding of how financial markets really work and what the implications of that are on a retail speculative trader. Luckily BabyPips and other sites are out there with great communities who can beat the ā€˜overinflated dreamsā€™ out of the noobs while at the same time showing them how to do it the right way with the right expectations.

Seriously guys? Spell check identifies BabyPips as a misspelled word! cā€™monā€¦ :stuck_out_tongue:

26

You fail to consider that for Trade 1 to exit the market with his 10 pips, he must either get Trader 2 to agree to end the trade (at a 10 pip loss, zero sum), or get someone else to effectively take his place as Trader 2ā€™s counter-party. Call them Trader 3. The gains to Trader 2 from the 100 pip reversal come out as a result of losses to Trader 3. Zero sum.

Thus far there has been no mention of brokers. The broker will extract the spread from each of these traders for profit. ā€¦ All parties are now reducing the finite capital in the market, and their future profits will all be reduced by the percentage of their respective gains. Also, one must assume that there is a fixed amount of money in the markets to begin with. In this instance, yes, this is a zero-sum game.

Technically, thatā€™s negative sum, but essentially correct.

The closest analogy I can draw is a Texas Hold ā€˜Em tournament. Eventually, there is a winner among the participants. The house (broker), however, always wins because of the entrance fee into the tournament (spread). Only one of the participants can win in the end because eventually there are no more chips available.

Exactly. If it were a finite game it would essentially be like a poker tournament where we would expect, over the long run, the best player to end up with all the money (less the houseā€™s cut).

Now add the circular component. There are more than just Trader 1 and Trader 2 in the market. There is more than just one broker. There is always an influx of money into the market from others. The previous analogy no longer holds true. Instead of a Texas Hold ā€˜Em tournament you have ring game at a casino. The game continues indefinitely with the house (broker) extracting a profit from each pot (spread). Each player can stay at the table playing poker until, theoretically, they have a profit, get up and leave. Each player may leave the table with a profit as long as new players (and their money) enter the game.

Iā€™m not familiar with ring games (donā€™t frequent casinos), but to extend the poker analogy we could compare it to online poker where players can come and go, creating a theoretically limitless game.

This is almost exactly how forex works. Until either the entire worldā€™s supply of capital is exhausted or there are no new traders entering the market, each participant can, theoretically, win.

Not true. While anyone can be a winner at some point in time, and theoretically almost everyone can end up a winner, there must still be at least one loser and that loser has to lose all of the cumulative gains of the winners. In forex and in poker, the winnings are always offset by the losings (leaving out the house/broker for the moment).

I think the confusion comes from the idea that money is coming into the game. It really doesnā€™t. It only passes through it. In poker, only the money which is actually gambled can be won or lost. I could have an infinite bankroll, but if I only bet $100 thatā€™s all anyone can win from me (the rest of it is out of the game until I bet it). Each pot represents the cumulative bets of the players. One person will win it all, and the rest will lose what they bet - zero sum as noted above. Then the game repeats. You can play infinite hands of poker in infinite locations with infinite players, but because each round is always zero sum, the whole running game is zero sum. Money passes from losers to winners. None of it stays in the game and there is no external addition of money from a non-gambler source, so poker cannot create wealth, just move it around.

Retail forex is the same. Each trade is like a hand of poker. No new wealth is ever created. It merely moves from player to player, tending to shift from the weak hands to the strong ones in the long run. You can have more participants coming in, but they arenā€™t adding to the wealth of the market as the market has no wealth. This is the difference between retail forex and stocks. The stock market is wealth.

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Essentially, thatā€™s what it is.

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We basically agreed on almost everything.

I was trying to point out where those who do not see it as a zero-sum game tend to go a bit off track. In any event, I am not sure why any of this matters!

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John Leonard, You saved me a lot of time writing, and you said it better than I could. I fully agree with you. The circulair aspect is too abstract for a lot of people (not only here but also in real life).

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It matters because it makes forex a competitive market where in order to make money in the long run you need to be better than most other participants (as in poker). In a market like stocks you can make money just by taking part.

My PhD supervisor told me a story about a poker playing friend of his who did quite well during the boom years of poker, but when the gameā€™s popularity waned his performance faded. Why? Because the easy pickings werenā€™t there anymore, so he was playing against better players on average. There may be something like that going on now in retail forex based on the declining volume figures being reported of late.

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Not reallyā€¦it depends on who the players are and remember, the retail fx is just a small part of the whole marketā€¦
So while it may seem as zero sum, thatā€™s not the case when you consider the whole picture and not just the spot market.

32

Right. The whole of the forex market is not zero sum because in places actual assets (currency) trade hands as opposed to just obligations which are the basis of retail spot forex (making sure to clarify retail because in the interbank spot market currency does change hands).

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Rhody,

I am not certain about it, but arenā€™t you forgetting the involvement of the broker? I am sure that they hedge the netted som of all the retail client positions. Either against their own true market positions or on the market self. This makes a connection to the market, making it part of the whole FX-market.

If I would be a broker, I think I would make sure that I hedge. I wouldnā€™t like to pay the difference if all (100%) my retail traders go long and they make a nice 100 pip profit. This would be a ā€˜market riskā€™ for the broker, that they almost certainly have covered.

34

Nope. Not forgetting the broker. They do indeed look to be net flat, but the dealing/market making ones at times do have an exposure they hedge away. They do so by entering into offsetting contracts with other brokers and liquidity providers. That connects them to the broader forex market, but doesnā€™t change the zero sum nature (still there is no actual currency exchange happening).

Think of it like a portfolio manager in the stock market wanting to hedge against a downside move in the broader market by going short the S&P 500 futures. As Iā€™ve note previously in this thread, the stock market is not zero sum as the wealth of the whole market can rise and fall. The stock index futures market is, though, because itā€™s based on obligations exchanging hands, not actual assets. Letā€™s say stocks rise, so the portfolio managerā€™s short is working against him. That means heā€™s transferring money to the speculator whoā€™s long on the other side of his hedge. Thatā€™s a zero sum relationship in that the two parties together are on net neither better nor worse off because the speculator is up the same amount of money the hedger is down in this case.

Now, we can say ā€œBut the portfolio manager is actually not worse off because he was just hedging.ā€ True enough in that if the hedging is done right his overall change in portfolio may actually even somewhat positive after the losses in the futures are factored in. The zero sum crux of the matter, though, is that the portfolio manager is worse off for doing the futures trade. Had he not put on the hedge his overall wealth would be higher by exactly the same amount of money as he lost in the hedge. The wealth effects to the portfolio manager and the speculator on the other side of the trade exactly offset - a zero sum market operating within a bigger non-zero sum market.

Yes, of course there may be very good business reasons for hedging, but they do not directly relate so donā€™t really factor into whether the trade/market is zero sum.

35

So if I understand you correctly. The FX market is non zero sum, but the retail section of it isnā€™t. The retail section is zero sum based as there is no actual exchange of currency as the exchange is only in the books of the broker.

Just trying to understand.

36

Correct but think of the spot market and by extension the whole market more in shades of grey rather than black and white, for one simple reason, the market is an evolving market. In other words, what may be applicable now, need not necessarily be so in a decade.
Given that, all we can say at this time, is that the spot market is zero sum while the whole market is notā€¦

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There is never any exchange of currency, even on the books of the brokers. All youā€™re doing is entering into an agreement to do a future exchange (technically in 2 business days) - which is where the obligation/liability bit I mentioned before comes in - but because of rollover that exchange never actually happens.

38

So I understood it correctly?

39

Aside from the part about the brokers, yes.