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Why Forex is a Zero-Sum Game

Prospera · 8 · 2117

Prospera

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on: Jan 22, 2013, 11:14 AM

Retail Forex Trading is a Negative Sum Game


FXstreet.com Independent Analyst Team Thu, Jan 17 2013, 15:32 GMT
by John Forman | FXstreet.com Independent Analyst Team

A little while ago, Richard Olsen authored an article titled Trading Forex Is A Positive Sum Game. In it he talked about how both sides to a trade derive some kind of value – referred to as utility - from doing the transaction. Using the broad definition of utility, Richard is certainly correct. We each get something out of doing a trade, though we may not always know exactly what that is at the time. It’s like Ed Seykota’s famous comment from the original Market Wizards book – “Win or lose, everybody gets what they want out of the market.”

I do have to disagree with the article in one respect, though. Dr. Olsen is a well-regarded researcher in academic circles, but he was incorrect in one aspect of his discussion. He made the case that even if we look at forex trading strictly in financial terms (gains and losses) it can still be positive sum. His argument is two-fold. First, he makes the case that market participants can come at the game from different perspectives (like long- vs. short-term) and that the markets are infinite rather than finite multiplayer games. Second, he argues that currency values can rise and fall broadly, increasing or decreasing their holder’s purchasing power as a result.

While these arguments, especially the latter, can be viewed as making a good case for the overall forex market not being zero-sum, they fail in the case of the retail spot forex market, which is likely where most readers of this article operate. I’ll address both here, starting with the second.
There is no currency in the market
The argument that currency holdings can increase or decrease in terms of purchasing power because of the way not only exchange rates, but other prices (gold, oil, etc.), move only works in a market where there actually are currency holdings. This is certainly applicable to the inter-bank spot market where traders actually exchange one currency for another.

Such, however, is not true of the retail forex market because no currency ever gets exchanged there. It is a market without assets. Each transaction is an agreement between parties to do a future exchange - which is the same as in the inter-bank market - but any position held through day-end gets rolled forward, so the agreed upon exchange is perpetually pushed forward until offset by an opposing transaction. Retail spot forex is thus like the futures market (exchange of contracts) more so than the stock market (exchange of assets).
And by the way, the money put into a retail trading account cannot be considered to be “in the market” because it is never used to purchase anything. It is there simply to ensure the trader is good for any losses suffered trading so their broker’s credit risk is limited. It’s not like the down payment on a mortgage or the amount posted for margined stock purchases, as those are actually used to purchase something.
Your gain is my loss
That brings us back to the first part of Dr. Olsen’s case against forex being zero-sum. It ties directly in with the contract-based market structure of retail forex noted above. When we put on a position we enter into an agreement with a counterparty (or more than one) whereby one of us is long and the other short. The one who is long will benefit as the exchange rate rises, while the short will benefit as the exchange rate falls.

same $10,000. If, instead of rising, EUR/USD falls to 1.10, then the situation would be reversed, with you losing $10,000 and me making that same amount.

Notice in this example how the combined net position of you and I doesn’t change. Your gain is my loss, and vice versa. Total wealth between the two of us does not rise or fall. It merely changes hands. It is like a hand of poker where the winner gains all the money in the pot, but since that is just money he and the other players bet, with no additional money being added, the overall wealth at the table doesn’t rise or fall. It merely moves from the losers to the winner. That’s a financial zero- sum game in both cases (though it could be positive sum in terms of broad utility as noted above).
We can’t all win
Now for the subject of players in multiple investment horizons and the idea that everyone can profit. Dr. Olsen makes this case in his article, but I think he was speaking in broader terms, not specifically of retail forex. I’ve seen this argument made many times in the retail context, though, so it needs addressing.

The bottom line is it’s mathematically impossible in the context of retail spot forex trading for everyone to profit. In theory everybody but one trader could be profitable, but not all of them. Because each position has to have both long and short sides, it is a net zero market balance (+x for long + -x for short = 0). It doesn’t matter how many players the game features, the turnover rate, or how long it runs. The market balance must always be zero because of the requirement for there to be a short for every long, and viceversa.

Let me demonstrate.

We’ll start with a simple 2-person transaction whereby Trader A goes long 100,000 EUR/USD at 1.20 with Trader B on the other side. If, as in the example above, EUR/USD rises to 1.30, then Trader A is up $10,000 and Trader B is down $10,000 – no net change in wealth for the overall market.

Let’s say Trader A wants to exit the trade and walk away with his profits. To do that he needs to either get Trader B to end their contract, or to find someone else to do an offsetting trade. He finds the latter in Trader C, so now Trader A is flat with a $10,000 gain, Trader B is short with a $10,000 loss, and Trader C is long with no gain or loss yet. Everything remains balanced.

If EUR/USD continues to rally and rises to 1.40, Trader C now has a $10,000 gain and Trader B has lost another $10,000, so he is down $20,000 overall. Add in Trader A’s $10,000 gain and we’re still at no net gain or loss for the market as a whole. Still zero-sum.
You can have as many traders coming and going as you like, for as long as you like, doing as many transactions as you like. Because every position must entail offsetting long and short sides, it will always balance out. Wealth is never created, just passed around among market participants. It is financially zero-sum.

Actually, in practice retail forex is a negative sum proposition for traders. This is because they are predominantly price takers, so on the wrong side of the bid-ask spread. Some pay commissions to their brokers as well, adding to the cost. Also, there is a bid-ask spread in the carry interest paid/ received when holding positions overnight (traders receive the lower rate for the long currency, pay the higher for the short currency). That means carry interest is also a negative sum factor because Trader A will receive less carry interest than Trader B pays, or vice versa. The result is that wealth is slowly shifted out of the cumulative accounts of the traders and into the hands of the brokers and market makers.

Why does any of this matter?
The fact that retail forex trading is a zero/negative-sum game means it’s a competitive market. This is very different from an asset market like stocks where if you hold a portfolio sufficiently large, or something like an index ETF, you have been virtually guaranteed to have some gain in the long run, even if you have absolutely no skill. Such is not the case in retail forex trading, which is more like poker in that money will tend to transfer from the unskilled players to the skilled players over time.

You may be thinking at this point, “Yeah, but new players keep coming into the market to provide a ready supply of unskilled players to take money from.” That is certainly true. I would, however, make two points.

First, in order to benefit consistently from that stream of new players you actually need to make sure you are both better than them and that you are playing in an arena where you are mostly trading against them. You don’t want to be trading in an arena where it’s mainly those better than you. And because retail forex is not a place where currency hedging goes on, you cannot rely on getting much opportunity to trade against players who don’t really care if they gain or lose.

Second, as has been documented in many places of late, we’re not seeing the same kind of growth in activity in the forex market as we saw for many years. We may be seeing a contraction, in fact. At the same time, we’re seeing a surge in the popularity of so-called social trading (also known as copy trading), which means the proportion of skilled traders (assuming those being copied can be classified as such) in the market is effectively multiplied because of the accounts replicating them. That is a combination which likely will make the market more competitive.
Takeaways
So what should you take away from all this? Well, for one you may decide to look for a non- competitive market to trade (like stocks), or to let someone else trade for you via a social trading setup. If you’re reading this, though, you’ve likely already committed yourself to trading forex. That being the case, make sure to learn from those who have gone before you (both the winners and the losers), and until you have incontrovertible proof that you are among the skilled traders to whom the trading profits tend to flow in the long-run, keep your exposure to the market small. No need to give those stronger traders any more of your money than you have to as you try to join their ranks.
-

Follow FXstreet.com Independent Analyst Team   website

John Forman is a 25 year market veteran. He is author of The Essentials of Trading and Trading FAQs, and until recently was Senior Foreign Exchange Analyst for Thomson Reuters. John is currently a PhD candidate researching trader performance.

« Last Edit: Jan 22, 2013, 11:18 AM by Prospera »


Rothschild

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Reply #1 on: Jan 22, 2013, 11:18 AM
mahirap talaga when you view currency like a commodity...


bajoyjoy

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Reply #2 on: Jan 22, 2013, 11:34 AM
really, really steep learning curve to succeed in forex trading. my cousin was forced to go back to the traditional employment as investment banker after about 5 years of going full time in forex (in fairness he was doing well but reduced his trading activity when he got married and started a family middle of last year). He earned for me about 15% of the capital I asked him to manage for more than 2 years. He’s still into forex, though hindi na daily trading.


Prospera

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Reply #3 on: Jan 22, 2013, 01:01 PM
^Don't you even want to try and see for yourself  bjj? :-)

After all, the forex expert Boris Schlossberg says forex-trading is no more speculative than stock-trading:

"My point is that in our modern world there are no investors, only speculators. Stock guys can give you a very nice story about growth and valuation but at the first sign of price declines they will bail. ( And please no emails to me about how you are all long term holders. Remember -- long term in asset markets is decades, sometimes centuries). So if everyone is a speculator then you might as well trade in the biggest spec market of them all. At least in FX you won’t have any illusions as to where you stand."


bajoyjoy

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Reply #4 on: Jan 22, 2013, 01:20 PM
^Di ko keri. I am intimidated by the enormity of the currency market (even the platform, nakakanervious! hahaha), and I’m not as TA-savvy as you prospera. How long have you been in fx anyway? In your opinion, is it really a sustainable livelihood?  Would you recommend it to your own relative/family member?


chiz_wiz

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Reply #5 on: Jan 22, 2013, 02:00 PM
i think giving up ur day job to trade forex is " a-not-so-wise " move, pwera na lang kung talagang magaling ka talaga mag analyze kung ano nangyayari sa market, .. hehehehe...
kaya ako demo trade lang muna, sa spare time, concentrate muna sa board exam review... tapos post din dito pa minsan minsan.. hehehehhe...



Prospera

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Reply #6 on: Jan 23, 2013, 10:09 AM
^Di ko keri. I am intimidated by the enormity of the currency market (even the platform, nakakanervious! hahaha), and I’m not as TA-savvy as you prospera. How long have you been in fx anyway? In your opinion, is it really a sustainable livelihood?  Would you recommend it to your own relative/family member?


@bjj: I asked only because I recall you said you attended Mark So's forex seminar before. And since you trade stocks already, I just didn't think it would be such a big leap.

There are people who do make a living off forex-trading. That's my ultimate ambition, as a matter of fact--ever since I stopped dabbling and started taking it seriously more than 5 years ago. (I'd still want to be doing other things, though, of course... but more for the psychic, rather than monetary, reward).

As for recommending it to others as a career-choice, perhaps not.  They have to make that determination for themselves, right?


myfxlife

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Reply #7 on: Jun 22, 2014, 05:43 PM
^Di ko keri. I am intimidated by the enormity of the currency market (even the platform, nakakanervious! hahaha), and I’m not as TA-savvy as you prospera. How long have you been in fx anyway? In your opinion, is it really a sustainable livelihood?  Would you recommend it to your own relative/family member?

:hello:
In my own personal opinion, Forex is a form of investment, just like investment in stocks, the difference between them is that, when you buy stocks, you're buying a share in the company's capital wherein you'll become a shareholder, so when the company becomes profitable then you will receive dividends or the value of the stocks rises which you can sell them for a profit, while in forex, when you buy a currency pair like EUR/USD, it means you are expecting that the value of EURO will rise versus the US Dollar so your investment profits or vice-versa if the value of EURO falls below the market price then the value of your investment lessens or you may loose all your money if the price continues to fall down. Just like in stocks if the company becomes bankrupt then your share also loses it value.
 :rolleyes:


 


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