What is Zero Sum Trading?

“…winning traders can only profit to the extent that other traders are willing to lose. Traders are willing to lose when they obtain external benefits from trading. The most important external benefits are expected returns from holding risky securities that represent deferred consumption. Hedging and gambling provide other external benefits. Markets would not exist without utilitarian traders. Their trading losses fund the winning traders who make prices efficient and provide liquidity.” Lawrence E. Harris (homepage), Chair in Finance, University of Southern California

Do you want to learn more? Download the PDF. This free report is about zero-sum trading, the single biggest reason trend followers win. In the long run, winners profit from trading because they have some consistent advantages allowing them to win slightly more often and, upon occasion, far larger profits than losers. Trend following provides those consistent advantages.

An Extract from the Trend Commandments on the Subject of Zero-Sum Insight Trading

In a zero-sum game, someone can win only if somebody else loses.

On any given market transaction, the chance of you winning or losing may be near even, but in the long run, you will only profit from trading because you have some persistent advantage (read: mathematical edge) that allows you to win slightly more often than losing.

If you have ever played poker or studied edges in gambling, the words ring true: To trade profitably in the long run, you will know your edge, you will know when it exists, and you will exploit it when you can. If you have no edge, you can’t trade for profit. If you know you have no edge, but you are trading for other reasons, you will lose.

The players in markets who lose over the long run are generally commercial hedgers. The reason for this is that hedgers use the markets for risk insurance, and insurance premiums always cost money. Of course, other speculators with bad strategy can provide winners with their gains too.

As counterintuitive as it seems, if you buy higher highs and sell short lower lows, and you use solid money management to manage and exit trades, you can find a mathematical edge in the long run. This keeps you opposite hedgers as much as possible. It is not rocket science by any means, but it holds up over time very robustly.

The market is brutal. Forget trying to be loved. Need a friend? Get a dog. If you are going to win, someone else will lose, either through their hedging or their bad strategy. Does survival of the fittest make you uneasy? Stay out of the zero-sum game.

Read more like this in the Trend Commandments Book by Michael W. Covel.

Who Are the Losers in the Zero-Sum Game?

Harris’s academic framing and the Trend Commandments passage together identify three categories of losing counterparties that fund trend following returns.

Hedgers are the most important. A corn farmer who sells futures contracts to lock in a price for next season’s crop is not speculating. They are buying price certainty. They pay for that certainty in the form of the expected loss on the futures position when prices rise above the locked-in level. This is a rational, utility-maximizing transaction for the farmer: the certainty is worth more to them than the expected return from holding the unhedged exposure. The trend follower who takes the other side of that hedge and rides the price trend does not need to be smarter than the farmer. They need only to be on the right side of the structural transaction that the hedger requires.

Speculators with bad strategy are the second category. The fundamental analyst who holds a position through a 40% decline waiting for the market to validate their thesis is providing capital to the participants positioned in the direction price is actually moving. The retail investor who sells at the lows during a panic is transferring capital to the participants who are buying at the lows. The performance-chasing investor who allocates to the strategy that just had its best year is providing capital to the participants who are in the next strategy to outperform. Each of these behaviors is predictable, systematic, and produces consistent returns for the participant on the other side.

Gamblers are the third category Harris identifies. The participant who trades for excitement, social stimulation, or the pleasure of the action rather than for expected return is not competing for profits. They are consuming a service, and they pay for it in the form of expected trading losses. Their presence in the market funds the liquidity that the systematic trader needs to execute efficiently.

The edge is not hidden or mysterious. Buying higher highs and selling short lower lows with correct money management is the structural description of how to position on the profitable side of all three categories of losing counterparties. Hedgers need to sell into strength. Speculators with bad strategy hold losers and exit winners. Gamblers trade randomly. A systematic approach that follows price trends in both directions, sizes positions correctly, and exits according to defined rules captures the structural advantage that these counterparties provide year after year.

Frequently Asked Questions

What makes markets zero-sum?

Because every futures contract has a buyer and a seller, and the gain of one is the loss of the other. When a trend following position captures a 30% move in crude oil, the participant on the other side of those trades lost 30% on equivalent exposure. The total gains and losses across all participants in the futures market sum to zero before transaction costs. This is different from equity markets, where the positive long-run return on stocks means the aggregate is not strictly zero-sum, but the short-run trading dynamics are approximately zero-sum and the structural advantages of systematic approaches still apply.

Why do hedgers consistently lose money to systematic traders?

Because hedgers use markets to purchase price certainty rather than to maximize expected return. The farmer who sells futures to lock in next season’s crop price is buying insurance. Insurance premiums represent a structural transfer from hedger to speculator. The systematic trend follower who takes the other side of the hedge is the insurance provider, and the premium is the expected return from holding the position. This is not exploitation. The hedger is making a rational transaction. The return to the systematic trader is the fair price of providing the risk transfer service the hedger needs.

What is the mathematical edge in trend following?

The combination of buying into price strength (higher highs) and selling into price weakness (lower lows) with correct money management. This positions the trader on the same side as the large, sustained price moves that produce the large wins, and uses defined exits to limit the size of losses when the signals are wrong. Over a sufficient number of trades across a diversified portfolio of markets, this approach produces a positive expected value because the large wins are larger than the frequent small losses, and the structure of the approach keeps the trader on the correct side of the hedger and bad-strategy-speculator transactions that provide the consistent source of returns.

Trend Following Systems
Want to learn more and start trading trend following systems? Start here.