Day Trading: A Zero-Sum Game

If you’re a beginner trader looking to lose money as quickly as possible, day trading is a great way to do it.

A common email we get is from beginner traders wanting to start trading immediately, and often, they want to start with day trading. Having read a few books or watched some YouTube videos, these eager but inexperienced traders are prepared to compete with Wall Street’s elite, and they want their winnings now. However, empirical evidence overwhelmingly shows that day traders, especially retail day traders, consistently lose out to their long-term investing counterparts.

One study found that “…it is virtually impossible for individuals to day trade for a living, contrary to what course providers claim.” The same study also found that “97% of all individuals who persisted for more than 300 days lost money.” Another study found that “Less than 1% of the day trader population is able to predictably and reliably earn positive abnormal returns net of fees.”

So, why is it so much harder to succeed at day trading than long-term investing, and why are new traders drawn to it despite evidence that the odds are stacked overwhelmingly against them?

What is Day Trading?

​​​​​Day trading is a fast-paced, high-stakes approach to trading. It involves entering and exiting positions within the same day, sometimes within minutes. Day trading can be systematic and based on computer algorithms or use discretionary techniques like chart patterns applied to one-minute or five-minute candles. Day traders can trade stocks, commodities, CFDs, FX, or anything that has readily available and liquid price action. Given the high frequency and rapid turnover of day trading, the trader requires quality data, high liquidity, low commissions, (usually) leverage, and most importantly, the ability to stay calm under pressure.

The Game Theory of Day Trading

​​​​​​​The day trading profitability problem becomes apparent when looked at through the mathematical lens of game theory. Game theory is a branch of mathematics that deals with analysing situations with multiple variables and participants in order to facilitate decision-making.

Within game theory, day trading effectively qualifies as a zero-sum game, that is, a system in which the sum of profits and losses of all participants is equal to zero. Or in other words, in a zero-sum game, for one player to win, another player must lose.
This is broadly true for day trading, because it is not a form of investment so much as speculation. Day traders are not investing their capital in the underlying company or asset for productive purposes. Trading on the scale of minutes or hours, the day trader earns no dividends, the company’s forecasts or earnings do not change, and the company’s productivity is not improved. Instead, the day trader looks to exploit liquidity changes, order flows, supply imbalances, or simple market noise to turn a profit.

If that’s confusing, let’s use a metaphor. Imagine a poker game with four players, each starting with $100. In this game, for one player to leave the table with more than $100, another player must leave with less than $100. Because no new value is created at the poker table, the money can only be transferred between the players. The only way for the overall value of the table to increase is if another player joins in, but even still, the following hands played remain zero-sum. The same is largely true for day trading.

On the other hand, long-term investing can be a positive-sum game because the overall values of assets or the market as a whole can rise over time. For example, the overall value of a stock index grows over time as more investment is made into that index’s companies or if the underlying companies have increasing profits. Therefore, it is possible for your investment to grow without another market participant losing out. A long-term investor can still lose out to other market participants of course, but in favourable economic conditions, the overall market can have a positive skew.

Long-term investors allow the market to grow, as companies can put the capital invested to productive use. In a market of only day traders, however, the wealth does not grow; it is merely rearranged.

To be clear, I am not making a moral plea about winning and losing. I’m stating the mathematical reality of the systems at play.

Why does the zero-sum game work against a beginner investor?

The beginner retail investor is at an inherent disadvantage when it comes to day trading. Their opponents are mostly large financial institutions and professional traders. These competitors have access to better data, better execution speeds and prices, and lower latency. One study concluded that “Institutional investors are conclusively superior in intraday trading, reflecting their superior information.” Furthermore, the institutional investor often does more than just day trade. They’ll be spreading their risk with strategy or asset diversification, which allows them to stay in the game for longer.

The retail trader, meanwhile, has limited data, higher costs, slower execution speeds, and less diversification. This disadvantage can quickly turn a zero-sum game into a negative-sum game. If we go back to the poker example, imagine each player now has to pay a fee to the house to participate in each hand played. Not only do you risk losing money to the other players at the table, but the longer you play, the less money there is in circulation.

In almost no other situation would a complete novice willingly enter this sort of game dynamic unless they fundamentally did not understand the game being played.

So why are some beginner investors so interested in day trading?

To a certain type of beginner, day trading appears to be a skill-based game with unlimited opportunity. Their cursory knowledge of the markets leads them to believe that short-term moves are easy to predict, and more trades must therefore equal more profit. But this reality is far from true, as the vast majority of them quickly find out.

In reality, these first-time traders, are not primarily seeking growth from their investments, but rather, they are seeking the thrill of winning, the excitement of constant action, and the satisfaction of being right. Additionally, this type of novice trader is likely to assume the highest risk and face rapid financial ruin. One study of day traders found that “subjects whose emotional reaction to monetary gains and losses was more intense on both the positive and negative side exhibited significantly worse trading performance.” If you are trading as a means of thrill-seeking or entertainment, you are far more likely to lose.

Should you avoid day trading altogether?

No, that’s not what I’m saying. Day trading can be profitable. However, profitable day trading lies well within the realm of the experienced trader, as the overwhelming evidence shows.

Understanding the theory of trading is one thing. Dealing with practical aspects like liquidity, slippage, execution problems, and “hidden” costs in real time is a whole other aspect which you can only truly understand from time in the market. Managing these considerations under the intense time pressure of day trading takes on a completely new dimension.

If you have never run 1 kilometre before, you would not try to run a marathon. If you have never driven a car before, you would not start by entering a V8 supercar race. Likewise, if you have never traded before, you should not be starting with day trading.