Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Zero-Sum Game

What it is:

In finance, a zero-sum game refers to trades or investments in which one investor gains when another investor loses.

How it works (Example):

Futures and options trading is generally a zero-sum game; that is, if somebody makes a million dollars, somebody else loses a million dollars. The downside is unlimited.

Let's say IBM stock is trading at $100 per share. Now let's say Investor A purchases a call option on IBM from Investor B. A few weeks later, IBM is trading at $105 a share. The call option gives Investor A the right to purchase shares of IBM at $100 per share from Investor B. In this scenario, the buyer could use the option to purchase those shares at $100, then immediately sell those same shares in the open market for $105. Investor A wins, because he gets to buy something for $100 and immediately resell it for $105. Investor B loses by the same amount, because he has something worth $105 but has to sell it for $100. The $5 that Investor A gains is $5 that Investor B loses.

Why it Matters:

Zero-sum games are essentially bets. In the financial markets, for instance, speculators essentially place bets on the future prices of certain commodities. Thus, if you disagree with the consensus that wheat prices are going to fall, you might buy a futures contract. If your prediction is right and wheat prices increase, you could make money by selling the futures contract (which is now worth a lot more) before it expires (this prevents you from having to take delivery of the wheat as well). Zero-sum games have a bigger purpose in the markets, however; they provide a lot of liquidity to the futures market and help companies find a way to stabilize their prices and thus their operations and financial performance.