A zero-sum game is when a consequence (either positive or negative) of one party's action is offset by a counter party's consequence. For example, if Jon loses a dollar in a bet to Jim, Jon loses a dollar and Jim gains a dollar. The net result of both actions is zero.
Many people view the financial markets as a zero-sum game, but for traders within the financial markets it is actually a negative-sum game. For retail traders, this means that the odds of winning in the stock market can be low. While there are profitable traders, the profitability of those traders is dependent on a constant flow of losing (or missed profitable) trades by other participants. What many traders and investors fail to realize when they enter the market is that in order to make money someone has to lose money. If there are no losers, there are no winners and the markets cease to function.

In this article we will go over what a negative-sum game is, and also how it can be overcome. Remember, there will always need to be people losing money (or foregoing opportunity to profit) in order for the markets to function, therefore only those that gain a distinct advantage over those that are losing will not join their ranks.

The Negative-Sum Game
A negative-sum game differs from a zero-sum game in that a loss is not directly proportionate to the offsetting gain. In a game where there are limited funds, the pile of funds available to potentially winning participants shrinks. Therefore, new participants need to come into the game bringing in new funds, a few (or one) player end up with the remaining funds, or all participants eventually lose their money.

An example of this is poker, in which the casino takes a "rake" from each pot. If there are five players sitting at a table, and each player puts $20 in the pot, there is $100 in the pot. The first player to play then bets, and all other players' fold, the player who bet wins the pot. If the rake is 5%, the winner of the hand receives $95 for winning the pot, but his is less than what was put into the pot. The winner receives $19 from each player as opposed to receiving the full $20, and he only receives $19 of his own $20 back. This player may also pay a rake on his winning bet. All players may also have to pay a fee for each hour they play.

Therefore, what was bet is not equal to what was won, it is less. In poker, the rake is what makes the game negative-sum; in the financial markets commissions, expenses and fees have this effect. If a trader buys shares from another trader and makes $100 gross profit, the other participant either has lost money or has given up the opportunity to make the profit that the buyer made. The buyer makes $100 - $10 commission, netting her $90. The seller who lost or gave up the opportunity to make money also pays a $10 commission. The net result of these two participants is that $20 is lost to brokers by way of commissions in order for this transaction to take place. (Check out Full Service Brokerage Or DIY? for more.)

It becomes apparent that in order for one to survive in the markets, one must be skilled in the game and new money must continually enter the market if the game is to continue. If no new money enters the market, trades fail to take place and the game breaks down.

Winning in the Negative-Sum Financial Markets
There are several game theory strategies for competing in negative-sum games, yet if we assume that new money will continually enter the market to some degree we only need to be slightly more skilled than the owners of the money who are losing in order to make a profit. There are several strategies that can be utilized in order to be the one(s) who comes out on the winning end of the financial markets.

  • Make the game as close to zero-sum as possible: We can move the game more to zero sum by not overtrading. By trading too frequently, the commissions will make it very hard to make an overall profit. Since price changes are generally larger over longer time frames than shorter ones, we can take advantage of those price changes by trading less frequently and making commissions a smaller percentage deduction from profits and losses. Only trade when there is a high probability chance of making a profit beyond commissions.

  • Follow the big money: Following the "big money" means we want to be doing the same things that those who have been successful (thus creating big money) in the markets are doing. What it does not mean is listening to the media. Price and volume are what drive markets, thus pay attention to price and volume as these will provide keys as to where the big money is, and on what side of the market. (For more, see Build A Baby Berkshire.)

  • Don't get psychologically involved: The market does provide opportunities for the astute observer to make money when others fail to realize what is actually occurring. Becoming psychologically attached to a position or bias obscures the objectivity that the raw data provides. Traders must be dynamic and be willing to change their positions when situations and indicators show that they should. (Learn more in How To Break Bad Trading Habits.)

Summary
A negative-sum game is when the sum of traders' losses and profits is a negative number (this is what goes to the broker and covers other fees). In order to make an overall profit in a negative-sum game we must be more skilled than those that are losing money, and there must also be a constant flow of new money into the market. This is because in order for the markets to operate some traders must lose in order for others to profit. On a personal level we can profit from the financial markets by trading only when the probability of making a profit beyond commissions is high, by following the big money and not getting psychologically involved in trades. (To learn more, check out Paying Your Investment Advisor – Fees Or Commissions?)

Related Articles
  1. Fundamental Analysis

    5 Predictions for the Chinese Stock Market in 2016

    Find out why market analysts are making these five ominous predictions about the Chinese stock market in 2016, and how it may impact the entire world.
  2. Economics

    How Interest Rates Affect The U.S. Markets

    When indicators rise more than 3% a year, the Fed raises the federal funds rate to keep inflation under control.
  3. Investing Basics

    Financial Markets: Capital vs. Money Markets

    Financial instruments with high liquidity and short maturities trade in money markets. Long-term assets trade in the capital markets.
  4. Economics

    The Ripple Effect: Interest Rates and the Stock Market

    Investors should observe the Federal Reserve’s funds rate, which is the cost banks pay to borrow from Federal Reserve banks.
  5. Investing Basics

    Calculating Floating Stock

    Floating stock is the number of shares a company has available for trade in the open market.
  6. Investing Basics

    Financial Markets: Capital Vs. Money Markets

    Two commonly used components of the financial market are money markets and capital markets. Find out the similarities and differences between them.
  7. Stock Analysis

    Hedge Funds: Idiosyncratic Challenges to Fade

    With shifting monetary policy, we see renewed potential across many hedge fund strategies.
  8. Economics

    3 Economic Challenges Argentina Faces in 2016

    Learn about three challenges that the Argentine economy faces. How will President Macri manage capital controls, investor sentiment and fiscal deficit?
  9. Investing Basics

    The Five Biggest Stock Market Myths

    Stocks that go down must come up, right? Wrong. We bust this myth and four other common market misconceptions.
  10. Investing Basics

    A Breakdown on How the Stock Market Works

    Learn what it means to own stocks and shares, why shares exist, and how you buy and sell them.
RELATED FAQS
  1. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  2. What is the difference between shares outstanding and floating stock?

    Shares outstanding and floating stock are different measures of the shares of a particular stock. Shares outstanding is the ... Read Full Answer >>
  3. What is the difference between market risk premium and equity risk premium?

    The only meaningful difference between market-risk premium and equity-risk premium is scope. Both terms refer to the same ... Read Full Answer >>
  4. What is the difference between the QQQ ETF and other indexes?

    QQQ, previously QQQQ, is unlike indexes because it is an exchange-traded fund (ETF) that tracks the Nasdaq 100 Index. The ... Read Full Answer >>
  5. What is the difference between an investment and a retail bank?

    The activities and types of clients for an investment bank versus those for a retail bank highlight the primary difference ... Read Full Answer >>
  6. Will technology ever disrupt the role of the custodian bank?

    Custodian banks, along with other financial institutions that hold custodian accounts, are likely to be disrupted but not ... Read Full Answer >>
Hot Definitions
  1. Super Bowl Indicator

    An indicator based on the belief that a Super Bowl win for a team from the old AFL (AFC division) foretells a decline in ...
  2. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
  3. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
  4. Ponzimonium

    After Bernard Madoff's $65 billion Ponzi scheme was revealed, many new (smaller-scale) Ponzi schemers became exposed. Ponzimonium ...
  5. Quarterly Earnings Report

    A quarterly filing made by public companies to report their performance. Included in earnings reports are items such as net ...
Trading Center