Futures trading and forex trading: is it really a zero-sum game?

Are forex, futures, and stock markets a zero sum game?  Most of us have heard this notion bandied about by various pundits.  Yet  is it  true, or even relevant?

I believe the “zero sum” concept is important to understand, yet in many ways irrelevant.   The problem is that the notion of “positive sum” vs. “negative sum” is a generality that does not take into account that many of the largest market participants are not profit motivated.  Rather than a scarcity of profits, I believe there are enormous opportunities to profit.

A trader or investor who understands why this is so will be in a much better position to make sound decisions.

Which market participants are not profit motivated?

First and most important on our list is Government.  Governments regularly act in the markets to achieve policy objectives – Not to make a profit.  Governments buy and sell currencies, peg interest rates, trade treasury securities, buy mortgage bonds, and even at times take equity positions.   I am not going to use Bernanke’s “QE” programs as an example -  A this point that would be too obvious.  Lets Looks look at a central bank like the Bank of Japan.  It has been periodically intervening in the currency markets (to bring down the value of the Yen) for years.  Yet, during this time the yen has continued move in a long term uptrend..  In effect, the Central bank of Japan has Funded the profit of traders on the other side of the trade.

Or, consider what is perhaps the most famous currency trade of all time, George Soros’s bet against the Bank of England in the early 1990’s.  By attempting to maintain a currency peg (In the face of economic reality) the Bank of England essentially funded the Quantum fund’s profits.

Second, the the general investing public has an inordinate, well documented tendency to buy and sell all investment types at the wrong time.   In other words, investor underperformance is much worse than what one would expect from simple transaction costs.  The reality is at the margin, the great mass of pubic investors are emotionally motivated, not profit minded.

how is this documented?   It is documented in the difference between time-weighted and money-weighted rates of return.  Time-weighted returns are the headline returns we are all familiar with.  They are the ones that show up in marketing brochures, in the financial press, etc.

Money weighted returns take into account the timing of investor cash flows.  Think about it:  If investors on average tend to “load up” and make their biggest investments at market peaks, and “Go to Cash” or panic after steep declines, they end up being less-invested during good periods, and over-invested before a decline.  These fund flows impact the real rate of return (known as the internal rate of return) that investors get on their actual invested capital.

I have set up the following charts to help visualize the problem.  The first chart is of the time-weighted (conventional) return of “XYZ Fund,” which is ultra volatile but finished the period up 150%.  The second chart shows the net asset value (NAV) implied by the time weighted return, but also the money-weighted return that factors in investor flows.  The “investor flows” are simulated by investors adding $100,000 every time the fund closes the period over $25, and withdrawing $100,000 every time the fund closes under $25.  The fund flows are documented by the blue line.

I have exaggerated the volatility and investor flows to clarify the point, however this effect occurs in every investment product (mutual funds, commodity funds, individual stocks, hedge funds)  that I am aware of.   Typically, the more volatile an investment is, the worse the “investor flow” problem is.

Third, Commodity index funds are usually structured  and managed in a way that almost guarantees that they will be long term losers for investors (Do to the negative roll yield and other transaction costs).  In my opinion,  the commodity futures markets were not intended to be marketplaces where long term investors simulate a “buy and hold” approach to owning tangible commodities.   Successful futures market participants are either investors who act as (or invest with) informed speculators, or they are hedgers who have other economic interests.

I would bet that leveraged ETFs  have resulted in more investor losses, or “contributions to the market” than any other investment vehicle.  This is due to a few different factors.  First, the daily re-balancing that is needed to maintain constant leverage forces the funds to “buy high and sell low” repeatedly on a short term basis.  This is a huge NAV (Net asset value) killer.  The effect is very similar to the “time weighted vs. money weighted” return example above, but in the case of leveraged ETFs, he effect is clearly visible in documented performance.

These funds often get their leveraged exposure through futures markets.  This means leveraged ETFs are regularly dumping money into the futures markets – Funds that becomes available for more rational market participants to earn through more informed decision-making.

The last “non-profit seeking” participants we will consider are hedgers.   Now, hedgers are in fact profit seeking – The difference is that their profit-seeking is done the context of a larger economic interest.  For a true hedger, the profit considered is not the closed system of the market, but rather their broader economic interest.

For example:  If a coffee roaster knows it can make a profit at a certain price for raw coffee, it can make sense for it to forward-purchase contracts in the futures markets- Even if coffee ends up falling in price and it loses money on the hedges.    The economics of hedging work for commodity producers as well:  If a farmer knows he can make a profit on his future harvest at the current forward price, it can make sense for him to forward-sell a portion of his future crop to “lock in” current forward prices.  This is true even if prices end up rising.

Now – One key to understanding futures markets is that Speculators tend to take a position that is the net difference between long and short hedgers (Commodity purchasers and commodity producers).   Hedgers and speculators tend to be on opposite sides of the market. The activity of speculators is almost entirely coordinated by profit signals that come from market prices.   Given this, it has been theorized (By the economist John Maynard Keynes, for one) that speculators can earn a premium for essentially “providing a service” to hedgers.

Look – the bottom line is that there are ultra-sophisticated traders – such as  proprietary trading firms, HFT hedge funds,  and informed retail traders who range from impossible to extremely difficult to compete against.   This is the mistake that most traders make when they attempt to trade too frequently.  If you are doing things correctly, you should never consider your trading as competing against the market’s toughest competitors.  On the contrary:    Learning to identify opportunities that are driven by slower moving, non-profit minded market participants is precisely what can make the markets positive sum – from the perspective of an individual trader.

After this article, most readers navigate to other articles on “thinking like a trader” or this section on “trading strategies that work


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