Foreign Exchange Is NOT a Zero Sum Game
My first post after a while is stimulated by a post made by Priyadi. He wrotes about the sum game
which includes many form of transaction (positive-sum, zero-sum, and negative-sum). I’m not going
to write about what those mean (for that it would be better if you visit his site directly). It’s just that
there’s something tickles me about his comment on stock trading and foreign exchange especially
when he states that foreign exchange is either a zero-sum game or even a negative sum game
because of the price difference between buy and sell. He also states that in the short-run, stock
trading is a zero-sum game but on the long run, it becomes a positive-sum game since company will
issue deviden every year and that the company will also benefit from the added investment brought
by their stock buyers.
There’s some thing that I think should be rectified on this matter and I will go about one by one.
Foreign Exchange
On this kind of transaction, the trader will have profit if s/he got capital gain. There’s two kind of ways
to reach capital gain on forex trading. One is from price hike if you have buy new position and sell
liquidate to close it. The other one is from price fall if you have sell new position and buy liquidate to
close it. Either way, if the position is right, the trader could make some money.
But this type of condition doesn’t mean that foreign exchange is a zero-sum game in which the profit
for one person is the loss for the other. I will show you that foreign exchange could be ANY-sum game
(positive or negative) BUT NEVER a zero-sum game. Please look at the chart below.
I’m going to simulate how foreign exchange could be a positive-sum game. Take that you are buying
a Euro on May 9th at 12 PM for 1.2660. You then sell your share of currency on May 10th at 12 PM for
1.2758. This means that you could profit around 98 pips on 1 day.
Let’s say that someone from the other part of the world (let’s say his name is Kumar) have a different
view and position from you. Say that he actually bought Euro on May 4th and sell it on May 9th which
will result on 89 pips gain.
From that simulation, we know that Kumar sold us his Euro currency (and thus, we buy his) at
1.2660. At this point, he actually already gain 89 pips. Furthermore, with this position (from the above
scenario), we could further gain 98 pips. This means that from that trade, the buyers and sellers
actually have net gain around 187 pips which means that this kind of transaction is a positive-sum
game!
You might argue that Kumar has a potential profit of 98 pips if he hold on for one more day (between
9 and 10), so by selling us his currency at that kind of scenario, he actually misses that 98 pips
potential gain.
However, on any kind of money market exchange, we do not calculate things that does not yet
happened (such as potential profit or potential loss). This mean that that 98 pips potential gain is not
actually Kumar’s loss and thus this concur that foreign exchange IS NOT a zero sum game. It’s not
even a negative-sum game because the difference between the buy and sell position is accumulated
to your gain or loss.
Not satisfied yet? Let’s take another kind of scenario in which you got profit and Kumar got a loss.
Say that Kumar bought Euro for 1.2758 and then sell it to you at 1.2660. You then sell that 1.2660 at
1.2758. This means that Kumar’s loss is the same as your profit, but does this constitute a zero-sum
game?
Zero-sum game is a condition where a buyer’s gain is a seller’s loss. So does our gain (on this
scenario) is Kumar’s loss? Not necessarily. At the point of sales of 1.2660, neither Kumar nor you got
any idea where the forex market will move. It could be either going up or going down so at the point
of sales, Kumar is indeed at loss (and in fear that the market would plunge even further), but we don’t
know whether we will get a capital gain or not. At that point, the seller indeed suffer a loss, but the
buyer suffers nothing since the market isn’t moved yet. This constitutes as a negative-sum game in
which the seller suffers loss but the buyer suffers neither loss nor profit.
My point is, in order for a zero-sum game to take place, the buyer/seller must both at loss/gain at the
same time, not further after the transaction took place. So there’s nothing such as zero-sum game at
forex market nor stock market.
Stock Market
Needless to say that the scenario on the stock market will be pretty much the same and this will
concludes that there’s no such thing as a zero-sum game at the market due to the same reason I
state above.
In order for a zero-sum game to take place, the seller must suffer loss and the buyer must at profit
(or vice-versa) at the same time as the transaction took place. While on forex or stock market, this
kind of scenario will take place AFTER the transaction which of course will not constitute as a zero-sum
game.
One more thing to add. A company will only receive a new injection of investment at their IPO (Initial
Public Offering). So when you buy or sell a company’s stock at the stock market, you are buying or
selling a proportion of a company’s ownership but that doesn’t mean that the company will receive a
new injection of investment from you.
So if the company’s stock price is sky high on the trading floor, that doesn’t mean that the company is
injected with a sky high of investment. The only thing that the company could do to invite new
investment flow into the company is from issuing a new share.
I hope this short article could give us a glimpse of how stock exchange and foreign exchange market
works. And not the least, both are not a zero-sum game. It’s either a positive-sum game, or a
negative-sum game in which both are ignited by something called “Mr. Market” (I’ll write about this
later).