What is a ‘Zero-Sum Game’?
Zero-sum games are the total opposite of win-win situations – such as an agreement that creates value between two counter-parties – or lose-lose situations, like war and mutually destructive relationships for instance. In real life, however, things are not always so clear-cut, and winners and losers are often difficult to quantify. New traders get confused and do not understand that in trading, profits come from the people on the other side of your trade that are making the wrong decision. The reason that trading is difficult is because you have to out smart someone to get their money, how you do this is what gives you your edge if you are profitable. In all financial markets buyers and sellers are always equal and the time frame in which they are trading determines if their decision was the right or wrong one at the time of their trade. Your entry is someone else’s exit and your losses are in some one else’s account as profits.
A zero-sum game is a situation where one person’s gain is always equivalent to another person’s loss, so the total wealth for the players and participants in the game is always a net change of zero as a whole. The financial contract markets of futures and options are a zero-sum game with several million players. Zero-sum games are found in game theory, but are less common than non-zero sum games. Poker and gambling are popular examples of what a zero-sum game is since the sum of the amounts won by some players equals the combined losses of the others. The money at a poker table at the start of the game does not grow it is just redistributed to the winners from the losers by the end of the game. All of the casino’s profits come from the gambler’s losses and all the gamblers profits are taken from the casino.
Games like chess and tennis also fit this model becasue there is one winner and one loser they are always equal. In the financial markets, option contracts and future contracts are examples of zero-sum games, excluding transaction costs, for every long contract their is someone short the same contract. Some one has to sell a contract to create open interest and someone has to buy it, there has to be a winner and a loser at all times, one long and one short. Brokers and market makers disrupt the perfect balance of winners and losers by taking commissions or profiting from the bid/ask spreads. But, for every person who profits on a contract’s value going in their direction, there is a counter-party who loses who is on the other side.
However, the stock market is not a zero-sum game. A very common misconception held by many is that the stock market is a zero-sum game. It isn’t, since there is not always an opposite short position for every long stock position. With a stock the underlying company that goes public with the initial public offering is not going short they never have to buy back to cover the stock, they can keep the capital raised, the company wins with a profit, giving up ownership percentage for cash. If investors or traders as a majority are long a stock that is trending up with minimum short interest then there can be more profits on the long side than there are losers on the short side. The company and the investors can all be profiting making it not a zero-sum game.
