A game is zero sum because it only has a fixed amount of reward. It’s a negative sum game if that reward declines. Gambling is a negative sum game. Day trading is usually characterized as a zero sum game. When one day trader makes a profit, another day trader must have taken a loss. The idea that day trading is a zero sum game pervades trading advice sources. Take the following assertion for example:
Day trading is a zero-sum endeavor; it has exactly as many winners as losers. And options and futures markets, which are popular with day traders, are zero-sum markets. — dummies.com
Now, maybe I can forgive dummies.com, as it’s focus isn’t exactly investing and trading, but there are other examples as well.
Trading is a zero-sum game: Market moves aside, every dollar won by one trader comes out of the pocket of another trader. Day traders competing against Wall Streeters is the equivalent of a college football team (or Pee Wee team, depending on the day-trader’s skill) competing against a pro team. — Henry Blodget
Well, it definitely sounds like day trading is a waste of time and money and that anyone who does it is basically just being scammed or scamming someone. And of course we should trust the wisdom of these people, right?
Day trading is clearly seen by many as a zero sum game. However, is that really the case? It certainly would make sense if day traders were the only individuals who were interacting with the market and thus influencing price, but they’re not.
Day traders also engage in buying and selling of securities. According to research conducted by JM Chung, Hyuk Choe, and Bong-Chan Kho, day traders tend to couple with longer term investors, buying and selling from these investors, rather than each other. The authors analyzed data made available by the Korea Stock Exchange. According to the analysis, this activity reduces the bid-ask spread, which indicates that the practice increases liquidity in the stock market.
Therefore, when there is a shortage of normal buyers and sellers in the market, day trading activity allows the investor to buy and sell securities as needed, without suffering from excessive spreads. While I don’t have an extensive amount of data on the topic, I would argue that there is a net flow of value from the investment traders to the day traders, which acts as a “payment” for that liquidity.
This flow is possible because the contrarian trading nature of day traders couples day traders and investors: day traders often look to buy at a point when investors are generally selling and look to sell when investors are usually buying. Meanwhile, investors are able to profit because of the amount of value that is constantly being added to the market, and the larger anthroposystem.
The only time when day trading would become a zero sum or negative sum game is when the market becomes saturated with traders. But as this saturation occurs, profits diminish, driving some of the traders out of the market, thus allowing it to return to equilibrium. Indeed, the research indicates this very dynamic. When the bid-ask spreads decline, profitability of day trading decreases, and the number of active day traders decreases, and when the bid-ask spreads increase, profitability increases, and more day traders enter the market.
Risk still pervades day trading. The low margins, decently high transactions fees, and other factors reduce the profitability of the profession. Most people probably do lose money in the process. But extremely difficult is not the same as zero sum. And what’s odd is that the science indicates that day trading shouldn’t be considered a zero sum game. Yet somewhere, somehow, investors and traders, as well as financial analysts’ and other experts, came to the conclusion that it is one, and this unjustified assumption has just stuck.
This discussion suggests that there’s still a lot to learn about the nature of the stock market and related markets. Day trading, while around for quite some time, is still poorly understood, both by the academic community as well as those who participate in the markets themselves.
It would be really great to see the research by Chung et al. replicated using data from larger stock exchanges in various countries. It would be a great research project. But while it’s possible that things might be different outside of Korea, I don’t think so. It just doesn’t make sense that day trading is a zero sum game, contrary to popular belief.
Originally published on the Trading Politics publication on Medium.