Other than buy and hold strategies focused on specific companies in stock markets, trading is by construction a zero sum game (even negative sum game due to transaction costs). The profits of one are the losses of the other. No, it does NOT matter how you slice it. This means that, in these markets, there is a mathematical obligation to have lots of “losers”, on average. This has MUCH more far-reaching consequences than many people realize, including many traders, who don’t “see the forest” (big macro picture) due to an excessive focus on the trees (very short term strategies and indicators). I want to touch on a few very important aspects of this subject, which will surely be of interest for traders and total beginners alike. Read on!
Risk-Reward and Success Rates
Before we discuss the basics of the aggregate market and the consequences of the zero sum constraint, I want to introduce something well known to traders: each trade has a risk-reward ratio and that is important in the long run strategy of your approach to trading.
Suppose I expect a price (currency pair) to increase (or drop) 200 pips in a given time interval. I come to this conclusion based on whatever approach I generally have: a mix of chart analysis, price action analysis, technical indicator analysis, or whatever else. OK so I identified a profit opportunity. I estimate as best I can the probability of success.
Since I want to pocket that 200 pips (let’s say 2000$ to keep things simple) when I hit it and I want to not risk a reversal of the price, I set a take profit value: the system will automatically exit me from the trade (and I will realize the profit) if that magical price value is hit. That takes care of the upside.
Then I have to take into consideration the possibility that the price will NOT go my way and that I will lose. I estimate how much I stand to lose if the price goes “the wrong way” and I set a stop loss according to whatever method I generally use, but there should probably be some kind of consideration for 1) possible loss of my own money; 2) variance of the currency pair (probability of hitting the stop loss... perhaps even within an otherwise winning strategy!).
If I want a risk reward ratio of 1:2 (meaning I aim to profit twice as much as what I put at risk in my trade), I set a stop loss at 100 pips (if the price goes against me 100 pips, I will automatically be exited from my position by the system and I will realise the 100 pip loss, or 1000$).
That is my setup. I define my exit point on both sides, so I know in advance what I stand to win and what I stand to lose. This is basic trading and should always be followed as a rule. BUT... there is a bigger picture to look at in trading... let’s continue...
Suppose I use this approach all the time: I enter a trade when I have a 2R setup (win twice as much as potential loss of initial money). In this case, and continuing with my 2000$ profit and 1000$ loss example, if I am right 50% of the time, for 10 trades, I am correct 5 times (5*2000$ = 10 000$ profit) and wrong 5 times (5*1000$ = 5000$ loss)... I am profitable in the long run. If I am wrong 2 times out of 3, it means that for every 3 trades, I lose 2000$ (2 times 1000$) and I win 2000$ (1 time 2000$). I break even.
Simply put, my long run profitability is a function of 2 things:
A higher risk-reward ratio (I stand to profit 3, 4, 5 times what I stand to lose) has a lower probability of success and a higher potential loss on each individual trade because the take profit exit value AND the stop loss value are further away from the entry point. There is a clear compromise: aim to win more on each trade (higher risk-reward ratio), and decrease your probability of success, all else equal.
Now keep all this in mind as we continue...
The zero sum game in FOREX trading
Many individuals and institutions make incredible profits in currency trading. They use various strategies and they DO make profits year after year. I am talking about major profits here. Like in the hundreds of percent. What’s the recipe? Is there magic? NO.
There are 2 things that differentiate them from the others: 1) they may risk more, on average; 2) they are right more often than most others. Their success rate is high. The mix of strategies between setting appropriate stop losses, take profit values, time horizon of open positions, and human capital makes the difference between the winners and losers.
For total beginners: a zero sum game is a situation where if I profit, you lose, and if you win, I lose. The profit of one is the loss of the other. Since forex trading is a bidirectional position taking game in which you take one position (e.g. “long”) on a currency pair, and someone on the other side takes the opposite position (e.g. “short”), it is a zero sum game by nature.
Now the issue is that FOREX trading requires more losers than winners, because it is a zero sum game and the profits of the winners are very high and some are quite systematic, which mathematically means that there MUST be more than half of losers. To trade in FOREX and NOT be in a casino state of mind, you have to win more money than you lose, on average, and NOT count on “one big win” to compensate for your losses. OK, so you are in it to win on average and you understand it is a zero sum game...
Predators VS prey, or smart money VS dumb money
We are a few million retail traders in the market. The beauty of the forex market is its “hugeness” and the fact that it is mostly a MACRO indicator, like stock market indices. Unlike a specific stock of a specific company, it can’t be victim of price manipulation, insider trading, falsified profit reports, and one-off events for extended periods and it has clear market dynamics that ultimately reflect “macro fundamentals and policies” of the individual economies and relative to each other, with each currency also having its own personality.
If you forecast relatively well growth and the output gap, unemployment, inflation, interest rates and monetary policy, oil prices, and a few other key factors, AND you understand that what matters for forex trading is information, expectations, and “what is priced in”, you are trading with a clear macro picture in the back of your mind. This is what highly lucrative macro funds do.
In other words, if you see the big picture of the macro-financial global market AND you understand the dynamics and specificities of the currency pairs you trade (which are strongly influenced by the economies behind them), you already have a good edge.
If you add to this macro-financial backdrop the appropriate use of chart analysis, price action analysis, technical analysis, and a few simple technical indicators, you are significantly increasing your probability of being right on your currency pair forecasts, on average. THAT makes a difference.
If you are using the indicators that are available to all participants in the forex market and essentially doing like everybody else, and not combining this with “something different”, you are dumb money, which means you are easy prey for smart money. If you found a “trick” that works most of the time, GREAT! Use it! But be aware that you are walking on thin ice if you don’t understand the macro-financial picture and fundamentals, because human capital and “understanding markets” is special and different, and that makes a difference in a zero sum game. This goes WAY beyond “trading the news”, by the way. But I digress...
If we are 2 million day traders watching the same charts and identifying roughly the same patterns, 2 million times 1000 dollars is an interesting little sum. Smart Money (which may include your own broker, by the way!) knows that all of us little fish in the big forex ocean are going in the same direction, in a big school of fish... they set the net... they know the aggregate position and approximate entry point and average stop loss... They make a big counter-move with a one-off mega transaction to force us all into our stop losses (the market CAN move a few extra pips in the short run with major players making strategic moves with big-yet-hedged transactions), generating a bunch of predictable orders... you are wiped out... they got your money...
The zero sum game is a strategic chess game. If you do what everybody else does and you essentially use the same indicators, chart analysis techniques, and stop loss settings as the average traders of the market, you are dumb money with the risky illusion of doing fancy stuff. Big, profitable hedge funds and banks will always have a massive advantage, because they use technical analysis with quite advanced statistical techniques and they can temporarily move markets enough to take the other side of your trades and win.
Some patterns DO have high probabilities of success (e.g. Head and Shoulders) and you should certainly know them, how to spot them, and how to profit from them. But to have an edge, it may be help to add extra human capital that most others don’t go through the effort of acquiring.
The good news is that there are several categories of forex traders. We all have different risk-reward appetite and risk tolerance, etc. We could say that there are as many styles as there are traders, but to the risk of oversimplification, I would dare say that there are 4 types in the forex market:
The good news is that it is totally possible to be smart money as a normal, part-time forex trader. There is an initial cost, a “right of passage”... knowledge! Human capital is THE best investment you can make. The issue is that if you learn what ALL other retail traders have learned and you do what all others are doing, the zero sum game will one day get you. The price to pay for the zero sum game is to “be different” and acquire more and better human capital than the average. The good news is that MANY retail traders simply don’t bother.
Keeping your sanity
If you have to spend your time in front of the screen watching oscillators and price patterns, perhaps you are feeling a bit drained... like a gamer who spends all his time playing his video games or like a casino gambler waiting for that big chance to replenish his emptied pockets, you may feel a fuzzy sense of emptiness, even if it is all very exciting.
I fully understand the “excitement of the chase” – I like it too! But I also like to place my trades with a clearer macro-financial context in mind. It seems to be more logical to me, and markets make more sense when you understand the bigger picture. There IS logic in currency fluctuations, and that logic has roots in what is happening in markets and in the economy. Learning this is accessible.
Of course, ultimately, charts and technical indicators DO “integrate” the fundamentals into their trends, breakouts, and turnarounds. So we could say that charts and indicators are “proxies” for fundamentals. But it seems to me that I can foresee things coming better, more confidently, and slightly more in advance than with technical analysis and indicators alone.
To each his style, and I certainly do NOT think technical analysis is useless. I think it IS useful and I think it MUST be part of the toolkit of any trader. But I find it easier to keep my sanity and “have a life” by fully understanding “what is going on and why.” Things make more sense, and I can go rock climbing in peace :)
Like anything with added value, there is an “initial price to pay” – learning and integrating the knowledge. But I assure you, it becomes as easy as breathing once you “get it”... once you “see the matrix”, things become quite clear and you can feel confident, relax and have fun!
Knowledge is power. Be smart money.
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