The Biggest Secret In Forex Trading – Zero Sum Markets

Today’s article is going to focus on something which is really important in your understanding of the market, if your someone who’s been trading the markets for a long time and has yet to achieve any kind of substantial success then this article may just provide you with the ‘aha’ moment you’ve always wanted.

I named this article ‘the biggest secret in forex trading’ because I believe if more people really understood what I’m going to be sharing with you today they would achieve much greater success in the markets.

Unfortunately for reasons I don’t know, this ‘fact of the market’, rarely ever gets talked about on trading websites and books, I’m not sure if it’s because the people writing the books even know about it themselves, or maybe if they purposely choose not to discuss or talk about it.

The really strange thing is it’s one of the most important things to have knowledge on in the market, if nobody ever talks about this rule then that means either they don’t know this rule even exists or they know it exists but don’t want anybody else to know about it.

Believe it or not there are certain aspects of the forex market which make it very similar to a game.

Think of these aspects as if they were like rules in a game.

These rules directly impact the behavior of traders in the markets, it doesn’t matter if you’re a retail trader trading from home like you and me or a professional trader working in a hedge fund, your both controlled by this rule.

 

Poker And The Forex Market

 

Have you ever played poker before ?

In a game of poker how many winners are there at the end of a game.

One right ?

To win in a game of poker you must have the largest amount of chips/money at the of the game.

Where does this money come from ?

The other players!

How much you can potentially gain in a game of poker depends on how much money the other people have decided to risk, if there are four players in a game of poker and they all decide to risk £20,000 each, the person who wins at the end of the game will acquire £60,000.

There can only be one winner.

Now for the important part, the poker example described above is almost exactly how the forex market essentially works.

Contrary to popular brief no money actually gets made in the forex markets, instead what happens is it gets transferred from one set of people to the other, the same as in poker.

In trading the set of people who are characteristically said to always make money are the bank and hedge fund traders.

The money these traders make comes from the people who typically tend to lose money in the market, which are retail traders with no professional trading background.

Retail traders commonly believe the bank traders who consistently make money have strategies and tools which they don’t have access to.

For the most part this is incorrect, although they do have advantage when it comes to information flow (for example they may have a heads up on what impact a news event might have in the market before its released ) they generally have access to the same tools as us, the only difference is they use them in a different way.

Whereas retail traders will look at a chart of currency in terms of technical analysis i.e support and resistance, swing highs and lows etc the bank traders are looking at these tools to but from a different perspective.

I can sum the difference in perspective up with a statement.

Retail traders are trying to predict the market direction using price.

Bank traders are attempting to predict the market by understanding what the retail trader is going to do.

This shift in perspective is what most retail traders are lacking, they think the best way to predict the market is by using tools based off of price (basically all of technical analysis), they haven’t realized the reason the market moves is due to people making trading decisions.

What Really Happens In The Market

 

Each day in the forex market how much money can be made is entirely dependent on how many people decide to put money at risk.

If 100,000 people place a trade tomorrow and they have all risked £10 each  that means the maximum amount of money that can be made for that day is £1,00000.

Now if we woke up tomorrow and no one decided to place a trade then two things would happen:

Number 1 nobody would be able to make any money.

Number 2 the market wouldn’t move anywhere.

Nobody would make any money because there’s none at risk, the market wouldn’t move anywhere because no ones placed any trades.

This is why understanding the implication of what it means to be trading in a zero sum market can have a dramatic effect on your trading.

Whenever you make money on a trade how much you make is determined by how many people have lost, conversely when you lose money on a trade that money has been taken by another trader or traders who have anticipated the market direction better than you.

If your analysis focuses on anything other than identifying where people are gonna lose money then your potential profits will be much smaller than those who do.

The traders who understand what it means to be operating in a zero sum environment as well as several concepts that come with it are the people who tend to make it big trading forex, not because they use some special tools that we don’t have access to but because they’re looking for market conditions which are going to make lots of people lose money.

They know they only way for them to make profits is to identify a situation where a lot of people are likely to lose money by taking some course of action ( lets say placing a buy trade for example) then taking the opposite action, selling against the people who have brought.

This is why you commonly see people make gigantic profits during financial crashes.

Look at John Paulson for example.

When the markets crashed in 2007 he made 4 billion dollars in a single year betting on the mortgage crisis that would eventually bring about the major rescission which bought the financial integrity of the world to a standstill.

How was he able to make 4 billion in one year?

Because he knew a situation was setting up that was going to cause a lot of people heavy financial loss.

Simple. This is what you need to be doing when looking at your charts for trading opportunities.

Real Trade Examples

 

In my supply and demand article I talk about how the strength of the move away is not a determining factor in whether the zone is considered strong or not.

You may remember this image I used to explain the point.

Aviary Photo_130918180364375050

I want you to look at this image and think about the psychology of the people who are short when the market moves up creating this demand zone.

The banks have brought down here because they know if the market moves up all the traders who are short in the market will probably close their trades, resulting in the banks making significant profits.

Bank traders know trading forex is a zero sum game therefore their behavior in the market will always be based on making as many people as possible lose money.

Aviary Photo_130936257956449369

This is a common example of how bank traders take money from the retail traders.

Although this image is taken from the 1 hour of EUR/USD it could just as well be any time frame.

You can see I’ve marked an area in orange, this area is where the banks and hedge fund traders are placing their sell trades.

Before the market drops lower after the second arrow the traders who have brought would have still believed the market has the potential to move higher, it wouldn’t have looked like the market was about to drop, this causes some of them to continue holding their trades, another set of traders also perceive this an opportunity to join the trend, they identify this as a pullback so they’ll start placing buy trades with the expectation that the market is going to continue rising.

When the market does drop out the area many of the retail traders who brought on the big bullish candle immediately close their trades due to the shock of being faced with a sudden loss, this allows some of the bank traders to take profits on their trades because now there’s an influx of sell orders hitting the market.

You’ll notice a second move up into the orange area, this happens because the bank traders were not able to place their entire trade into the market on the large bullish candle, the market makers will purposely move the market back up into this zone to make retail traders buy again and make anybody who happened to sell on the down move close their trade resulting in even more buy orders coming into the market.

Now they have loads and loads of buy orders available to place the remaining sell orders from the banks.

When this is completed the market begins moving lower and eventually the process described above will repeat itself in the other direction.

Summary

 

The example I’ve shown you here is not an isolated incident.

It happens everyday on every currency on every time frame. The banks will always make the market move in the direction which causes the greatest amount of financial damage to the maximum amount of traders.

When you look at your charts what your really seeing is people making and losing money.

You too can trade like these banks.

All you need to do is think carefully about what it means to be participating in a zero sum game,  if you do It’ll change your perception of the market, a whole new dimension opens up when you begin thinking about how money really gets made and lost in the markets. Gone will be the days of just looking at technical levels and using them on their own to anticipate market direction, now you will be thinking about what the other traders looking at these levels are likely to do and basing your trade-off of that instead.

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1 comment

  1. Gilberto Camacho

    oh i never knew about this concept i wish i had learn this long time ago, and i am going to buy your book of How the large institutions operate in the markets, thank you for this great material. Gilberto Camacho

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