Does the following sound familiar?  By the time you are convinced a stock is good enough to invest, it suddenly changes direction and plunges.  And as soon that you give up and sell a falling stock it starts to rally.  Is the stock market reading your mind?   Perhaps the discussion below will help clarify this experience.

Derivative securities, such as options and futures, are contracts between two parties.  The party who issues or writes the contract is said to be short.  The party who buys the contract is said to be long.  When the market bids up the price of such security, the buyer’s gain is equal exactly to the loss of the short side.  Hence the term “zero-sum game.”  (Actually, the realized gain will be smaller than the loss, the difference being the the transaction costs incurred.)  It follows that in every contract trade, 50% of the traders gain at the expense of the other 50%.

Common stocks are different.  The stock you purchase is technically a liability to the issuing company, but it appears on its balance sheet as Shareholder Equity.  So when the stock price appreciates both sides gain.  More about the stocks later.

Here is the problem: How can some derivatives traders consistently make money?  (By “consistently” we mean on balance, not in every trade).  Regardless of any system a trader might follow, whether based on fundamental or technical analysis, if someone (or some group) is a consistent winner in the market, then someone else must be a consistent loser.  This is a dreadful though!  Who would stay in the market just to lose money again and again?  It is natural for those who lose money to change their strategy or exit the market.  Indeed, there must be a continuous supply of losers entering these markets, those who “supply” the funds to the consistent winners.

Given these facts, it is not surprising that studies have shown that only about 20% of those who participate in derivative markets consistently make money.  It is amazing how many books, systems, and now computer programs have been sold, which claim to help traders achieve fortunes in futures or option markets.  Millions of man and computer hours have been spent in the attempt to find the “perfect system,” the ultimate way to trade these markets.  Obviously some methods are better than others.  But whenever such a book or system is offered for sale you have to ask yourself:  if this system is really effective, then why give it away?  Since one trader’s gain is another trader’s loss, a good system will lose its value when it becomes known by other traders.

Zero-sum game markets, by their nature, behave differently than regular markets.  They are usually more volatile, yet the traditional method of portfolio diversification does not work as well.  Diversification is done to reduce the portfolio non-systematic risk.  But the more assets added to the portfolio, the more their average return approaches that of the market, which is not necessarily positive.

What distinguishes the small minority of consistent winners from the rest is simply superior knowledge.  We like to look at traders in these markets as comprising a “pyramid of knowledge.”  The most successful traders are at the top, followed by a larger number of less thriving traders, and so on.

When I first wrote about zero-sum game markets (in 1992), the discussion applied only to options and futures.  But in recent years, the stock market has been exhibiting more and more characteristics of zero-sum game markets.  One of the reasons for that is the proliferation of Exchange Traded Funds (ETFs) which make it easier to short specific sectors or the entire market.  When there are so many short positions in the market, a gain in a stock price might mean a loss to the short positions, leading to short term trading similar to derivative markets.