Game Theory: Is Forex a Zero-Sum Game?
Posted by Asaf Yigal in Forex, Game Theory, tags: forex brokers, Forex Trading, Game Theory, market makers, positive-sum, retail forex market, zero-sum
In the following few posts I’ll try to give a few examples of how game theory is applied to trading the forex market hoping to shed some light on the mathematical aspect of trading and the value of collaboration in this market.
The most common statement I hear from traders is “The forex market is an efficient zero-sum game market and therefore sharing information may expose my edge.”
So what is a zero-sum game and how do I know if the above statement is true? Let’s start by talking about game theory and the different types of mathematical games.
Game theory is relatively young and quite complex branch of mathematics applying math to structurally define strategic situations in games. Mathematical games are most commonly defined by the number of players, duration of the game, game sum (more on this in a minute), simultaneous/sequential, and information flow. So for example chess is a two player, finite, zero-sum, sequential perfect information game because there are two players, the game ends when one of the players wins, only one player can win, the players take turns in playing and each player sees the actions of the other trader. (This is what defines perfect information flow.)
Economy, in general, is a multi player, infinite, positive-sum (Hold on, I promise I will explain why this is), simultaneous, imperfect information game.
Zero-sum games are games where a win by one player means a loss by the other player; the term has little to no relevance when describing multiplayer infinite games. The reason economy is a positive-sum game is because it’s an infinite game where value is built throughout time due to value growth in the overall economy.
So what about retail forex trading? Is forex a zero-sum game?
The short answer is that it doesn’t really matter because it’s an infinite, multiplayer game. The long answer is that it’s not a zero-sum game and it largely depends on the way the broker operates. Brokers that operate as a dealing desk, for example, (also known as market makers) mathematically resemble the way a bookie operates in a horse race. This becomes a negative-sum game because mathematically the players in the game are all traders using the same broker.
So what is the best strategy to play in a multiplayer infinite game with imperfect information – like the retail forex market? – More on that in future posts …
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Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results.
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Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.
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Nicely said, by the way, have you thought about “Stop Loss Hunters”? Keep Chargin’
Be Awesome,
Raj, DreamJOBZ
Thanks for good article Asaf. I’ve been trying to find some info on whether Forex is a zero sum “game”. I’m still not quite clear on it though. If it is not a zero sum game, where do the profits come from for those who make a profit?
Yiannis,
It’s a complicated question to answer and it largely depends on the broker that you are using and the type of execution they have. Since most of the retail brokers are Market Makers they actually behave from a game theory perspective like bookie in a horse race – you place the bets and they take the risk on that bet – if your horse wins they pay you and if you lose they keep the money banking on the fact that most people lose.
For the brokers that act as ECN – they are actually sending the order to the bank to convert the money into the new currency you’ve requested and no one is taking any risk here. Because of the magnitude of the market Money always keeps coming in and out and support the liquidity needed to enable profits for people.
– Asaf.
Something people seem to skip over is the fact that there are people out there that use currency trading for hedging purposes.
In this instance their win or loss in forex is countered by a win or loss in some other area. With that in mind we don’t have a true win/loss relationship between every two players. We have a win/flat situation if the hedge was precisely carried out.
Forex is not a zero sum game! period! period!! period!!!
A zero sum game has odds of one to one. If you win you have two dollars. If you lose you have zero.
Due to slippage of ask/bid, ones overhead ie, cost of computer, cost of cable feed, and etc, etc, dictates that Forex is not a zero sum game.
Example; when you win you net 98 cents after above costs, when you lose your gross loss is $1.02 with above costs.. Run that out on your computer using random numbers. Absolutely no way to win!!!! It is mathematically impossible to win a non-zero sum game.
The most close you could come to a win, lets say at Vegas as an example, would be to place one bet. If you win walk away and never bet again. However the Pit Boss will not accept (one large bet win or lose) from a player.