What is zero sum game: Game theory is the study of mathematical models of conflict and cooperation between intelligent rational decision-makers. A game could be either a zero sum game or non-zero sum game. A zero sum game is a situation in which one person’s gains exactly equal net losses of the other participant or participants. Here one may think of stock market as a zero sum game as for every profit maker there is a counterparty making a loss of equal magnitude. Is it that straightforward or we are assuming few things to call it so? Let us find out.
Is wholesome stock market a zero sum game
Misconception about stock market and zero sum game: Every dollar that some investor wins in a stock market investment, some other investor lost – or will lose. There are many hands (many listed companies), many opportunities for individual wins and losses, but the bottom line is: every dollar of profit that any investor earns on the sale of stock was put into the market by another investor hoping to win.
Strictly speaking, the stock brokerage fees make the sum non-zero (negative). However, the fees are quite small compared to the average transaction, and can be neglected. Furthermore, most of the people arguing that the stock market is not a zero-sum game want you to believe the sum is positive; brokerage fees actually make it worse than zero, not better. The broker is like the house in a casino. The house always wins.
Another argument could be on the dividend side. Dividends are not included in either the purchase or sale price of the stock, so they are essentially irrelevant to whether the sum is zero. However, whoever happens to be the owner of record on the day the dividends are announced gets paid. Like the other leaks in the system, dividends are miniscule compared to the vast majority of stock trades, so their impact on the profits and losses in the market is negligible. Most people are looking for capital gains profits, not dividends. Many companies pay no dividends at all. Stockholders accept that.
Considering few such arguments, one can never be sure of whether stock market is entirely a zero sum game. However, one can be relatively more firm in saying such about one of its segments, i.e. Futures & Options (F&O).
F&O and zero sum game: An option gives the buyer the right, but not the obligation to buy (or sell) a certain asset at a specific price at any time during the life of the contract. On the other hand, a future contract gives the buyer the obligation to purchase a specific asset, and the seller to sell and deliver that asset at a specific future date, unless the holder’s position is closed prior to expiration.
Call Option Pay-Off Chart
Put-Option Pay-Off Chart
Futures and options trading are zero-sum games because for every investor holding a profitable contract, there is another investor on the other side of the trade who is losing money. The total amount of wealth held by all the traders in a zero-sum game remains the same, but the wealth is shifted from some traders to others.
However, one has to ignore the risk hedging benefits to call the game a zero sum.
Traders can use different strategies based on game theory for profit maximization. We will discuss some of such strategies in our next article.