Trading Is Not A Zero-Sum Game, It Is -EV

Trading and Poker as a zero-sum game is the new efficient market theory. I can't count the number of times I've heard that trading is a zero-sum game repeated without any fact based evidence what-so-ever. Let's look at the definition of a zero-sum game first:

a zero-sum game is a mathematical representation of a situation in which a participant's gain (or loss) of utility is exactly balanced by the losses (or gains) of the utility of the other participant(s). If the total gains of the participants are added up, and the total losses are subtracted, they will sum to zero.

So first let's disprove poker.

Buy into a 2/4 limit hold 'em with a $100 rack and post on the big blind. For sake of argument let's assume this is a 2-1-1 blind situation. If the first three hands are discarded, 4% of the rack is gone. If this is a full game of ~8 players and a hand count per hour of 35 you should be blinded 4 times. Without playing a single hand approximately 16% of equity will be lost in an hour.

Now to disprove trading.

I have a $1500 account. I buy 100 shares of XYZ at $10 for a total of $1000 and a commission of $7. I now have $1000 of stock and $493 in cash. I sell $XYZ the next day for $10 and a commission of $7 to you who has a $1500 account but with $1 commission. After this trade I have $1486 and you have $1000 in stock and $499 in cash. Let's repeat. I now have $1000 in stock and $479 in cash and you have $1498 in cash. If this repetition continued further, even though I bought and sold the same number of shares for the same price, soon enough I won't even be able to buy the same number of shares.

As long as there is a rake in poker and commissions in trading the game will always be -EV. The typical claim that trading is a zero-sum game is concluded briefly with, “For every winner there is a loser.” However, even this is not completely true as shown in the trading example. Further there is plenty of evidence that the game of trading is really a wealth transfer from the many to the few. A number of account studies have shown unequivocally that 90% of them are net negative and the owners of these accounts have a strong tendency towards the disposition effect: cutting winners short, letting losers run, and adding to losers but not to winners.

This is just one of many market maxims that when not vetted and taken at face value can lead to erroneous conclusions and outcomes, poor habits and thinking. One that I've recently thought about is “Trade what you see, not what you think.” The problem with this is that we now know through behavioral sciences that both are faulty and can not be relied upon unquestioned. When looking at a chart our eyes are subject to optical illusions and blind spots, and our thinking is subject to misidentify a trend based upon a sequence of 2 in a row among other behavioral biases.  Not only are they problematic individually, they can become more so when used in tandem. The moral of this story is: question first, verify second, believe third.  Reality based, evident backed trading trumps assumptions and maxims.