Fellow Forex trader Ed Ponsi argues that Forex trading is not a zero-sum game. I disagree with him and sent a rebuttal. The publisherhas not responded so I am reproducing the rebuttal here.
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IS FOREX TRADING A ZERO-SUM GAME?
Andrew J. Chalk
In a recent article (http://www.optionszone.com/learn-more/ed-ponsi/2009/03/is-forex-trading-a-zero-sum-game.html?sid=BR2135&en=1235844) Ed Ponsi made the claim that “There is a misconception among some traders that every trade must have a winner and a loser. There is a great deal of misinformation out there, and there have even been books published recently that incorrectly state that Forex trading is a zero-sum game.”
To prove his argument he used the following example:
“…suppose you enter a long position on EUR/USD and at the same time, another trader takes a short position in the same currency pair. The broker simply matches the orders and collects the spread. This is exactly what the broker wants, to keep the entire spread and maintain a flat position.
Does this mean that in the above scenario one party has to win, and one must lose? Not at all, in fact both traders can win or lose; perhaps one has entered a short-term trade and the other has entered a long-term trade. Perhaps the first trader will take a profit quickly, but there is no rule that states the second trader must close his trade at the same time.
Later in the day, the price reverses, and the second trader takes his profit as well. In this scenario, the broker made money (on the spread) and both traders did, too. This destroys the oft-repeated fallacy that every Forex trade is a zero-sum game.”
Let us go through this argument using cable as the instrument to create a concrete example. We will do the math on the way to see who is making money, who is losing money, and who is flat.
First, consider the case where there is a broker-dealer in the middle. This is not only typical, it helps to clarify the argument.
Cable is at 1.50
Trader A sells short cable. The dealer is now long cable.
Trader B buys cable, The dealer is now flat cable.
Cable goes to 1.00
Trader A covers his short. He is now flat cable. The dealer is now short cable..
Trader B maintains his long position in cable. However, he is down 0.50
Cable goes to 2.00
Trader Bsells his cable position. He is now flat cable. The dealer is now flat cable.
The wealth positions of the parties are now:
Trader A: +0.50
Trader B +0.50
Dealer: -1.00. He lost 0.50 to Trader A when cable went down from 1.50 to 1.00. He lost 0.50 to Trader B when cable went back up, past 1.50 to 2.00.
Net result: Dealer loss = Trader A’s profit + Trader B’s profit.
Forex is a zero-sum game.
Second, consider the case where there is no dealer. Trader A and Trader B still exist.
Cable is at 1.50
Trader A sells short cable.
Trader B buys cable from trader A. He is now long cable.
Cable goes to 1.00
Trader A covers his short. He is now flat cable. He cannot buy from Trader B, per Ponsi’s example, so let’s say he buys from Trader C. Trader C is now short cable.
Trader B maintains his long position in cable. However, he is down 0.50
Cable goes to 2.00
Trader B sells his cable position. He is now flat cable. However, he cannot sell to Trader A, per Ponsi’s example, so let’s say he sells to Trader C. Trader C is now flat cable.
The wealth positions of the parties are now:
Trader A: +0.50
Trader B +0.50
Trader C -1.00. Trader C has sold cable for 1.00 and bought it for 2.00
Net result: Trader C loss = Trader A’s profit + Trader B’s profit.
Forex is a zero-sum game.
Of course, Trader B could have sold his cable to Trader D, but a few minutes thought makes one realize that then Trader C and Trader D both have open positions (they are not flat cable). That can’t be the end of the analysis, it doesn’t add up. In order for this not to be a zero-sum game, you have to always have another person at the end of the line willing to close out the open position. And that would be a Ponzi scheme.
We might also address Ponsi’s argument by assuming that he s correct. It would be a wonderful world if it were. It would mean that we could invent Almighty Man. He would dictate the price of cable. He would first have Trader A go short and Trader B go long at 1.50. He would then drop the price to 1.00. Trader A could cover and claim his profit. He would then ordain the price of cable be 2.00 where Trader B could sell and claim his profit. Then he would have the whole sequence repeat – but starting at the terminating price of 2.00. Then repeat, as nauseam. This is, as they say, a money machine! No more recession, falling markets, etc. Almighty man is doing what a central bank can only pretend to do. Unfortunately, this is also impossible.
Finally, how can stocks be a non zero sum game but Forex not be so? Stocks are final claims to real assets. So an increase in the stock market is a real increase in national wealth. Forex instruments are ratios of national currencies, so changes in the exchange rate redistribute wealth but do not create it
