The foreign exchange (forex) market is arguably the worlds largest financial market which sees over $6 trillion in trades each day. Most of this value is accounted for by financial instruments known as FX swaps rather than simple exchanges of hard currency at the ‘spot’ or current market rate.
A unique element of the forex market is that every currency can be directly swapped for any other, resulting in a matrix of exchange rates between ‘currency pairs’ rather than a single list of prices denominated in a single currency.
This complex interrelationship between prices could see the Swiss Franc strengthen against the US Dollar on the same day that it actually weakens against the Japanese Yen.
As with any large financial market, there are opportunities for long term speculators and short term currency traders to make a profit from sitting on the correct side of a currency price movement.
However, because the appreciation of one half of a currency pair implies the depreciation of the other, there will always be an equal and opposite loss that matches the profit of the victorious trader. As both returns add together to zero, this gives rise to financial commentators referring to the forex market as a ‘zero-sum game’.
What the zero-sum game means for traders and investors
Trading in a zero-sum environment marks an increase in difficulty level for traders.
However, many wrongly assume that this presents an unsurmountable change in the odds of success compared to markets such as equities and corporate bonds, which have a positive expected return over time.
This is because over a short time horizon of one day (which is similar to the average length of a trading position), even the stock market isn’t so friendly to day traders. Statistical analysis by Einvestingforbeginners shows that of the 5,035 days between 1996 and 2016, the US stock market only closed the day up 53% of the time. This means that the market fell 47% of the time, even though the stock market has experienced an upward prevailing trend over that time.
The takeaway is that when trading short-term price movements, even equity markets can look and feel like a zero-sum game, where a blind bet has a virtually equal chance of winning as losing.
Statistical probability theory suggests that the more trades made in a zero-sum market, the more likely it is that an individual’s trading results will converge upon the average movement (nil).
This places trading fees in sharp relief because unlike the underlying performance of a trade, a trading fee places a downward bias on returns. Fees drag down the performance of a portfolio; particularly one that is churning its capital frequently.
Platform and other broker fees will also be responsible for raising the bar a trader needs to clear to make a profit on the forex market. Therefore it’s crucial that new traders perform a good comparison of different desktop trading platforms to ensure that they are paying a fair price for the total service a broker provides.