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Pre-note: Although I am trying to make this question general, in the case that there are any ambiguities, I would like to direct this question toward cryptocurrency futures trading platforms that offer leverage


In general, when it comes to trading, one can make the statement "for every person that gains money, someone else loses money".

What this means is that the net outcome of an entire system is zero, i.e the profits and losses sum to zero.

This is indeed the case between two time periods if the opening and closing price of a stock happens to be the same. However, if the closing price is greater than the opening price, then the net outcome in that time window is positive/profit, and vice versa.

So in simple terms, if the general trajectory of a price is upwards then there are more people making profit than making losses.

In general, when the economy is going well, you do expect more people to be making profits than making losses.

However, this begs the question, how is this net positive outcome achieved when trading with leverage pools?

Those that put money into these pools are expected to be able to eventually take that money out (let's forget for a moment that they also intend to make interest).

However, if more people are making profit than making losses, doesn't money have to be taken from the pools to be paid out to gainers, which results in the available money in the pools shrinking? Is this the case, and if so how does this not pose problematic? What solutions are used to prevent this in these pools?

The only solution I can think of is to force the system to be a net zero outcome (where there are equal gainers and losers) or a net negative outcome (where there are more losers than gainers). This solution could be achieved through transaction fees, funding fees, lending fees, etc. Is this the case in these pools, is the net outcome forced to not be positive? If so, wouldn't people be less likely to use these leverage pools?

One of the things that makes me confident when investing money is that long-term (assuming the economy is going well), there are more gainers than losers. Is it possible to still have this confidence in leverage pools? Or are there more losers than gainers? Because it seems to be that you can't have this confidence, because it seems to me that leverage pools have to force a net zero or net negative outcome.

It would be great to get clarity on this, please let me know if my question is too complicated and needs improvement.


Edit: This question seems to apply more to future/perpetual markets, where you are in a closed system. When working with the actual underlying asset, profits are also gained from selling to people outside the leverage exchange you are using, so this problem doesn't seem to exist here.

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  • $\begingroup$ Welcome new user, it's very likely you would ask this interesting question on the Economics site. (This site is for things like "how do I use my chequebook?") $\endgroup$
    – Fattie
    Feb 15 at 20:35
  • $\begingroup$ @Fattie Hey thanks for letting me know. Perhaps the quant site is even more appropriate $\endgroup$ Feb 16 at 8:43
  • $\begingroup$ good thinking @davidcallanan $\endgroup$
    – Fattie
    Feb 16 at 12:22
  • $\begingroup$ "leverage pool" and "leverage pools" are not defined by Google. It appeared 11 times in your post. $\endgroup$
    – base64
    Feb 16 at 16:00
  • $\begingroup$ @base64 Yeah maybe that's incorrect terminology (although I have heard it before). I'll see if I can find a better term, but what I mean is pools that people put their money into that is loaned out to traders that use leverage. $\endgroup$ Feb 16 at 17:08
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Warning

I am currently editing this answer, as I feel like I might have come to incorrect conclusions. (Maybe I didn't, but I am putting this warning in place in case I did). I hope to update this answer with more information soon.


Answer


It appears that a futures market is a zero-sum game.

Futures markets

the sum of all the long positions must be equal to the sum of all the short positions. In other words, risk is transferred from one party to another is a type of a zero sum game

Zero-sum game

a zero-sum game is a mathematical representation of a situation in which each participant's gain or loss of utility is exactly balanced by the losses or gains of the utility of the other participants. If the total gains of the participants are added up and the total losses are subtracted, they will sum to zero

See also another interesting question related to this topic: Where does the profit come from in short selling futures?

Conclusion

When it comes to futures markets, whenever you gain, someone else is losing. This differs from spot markets where, if the general price trajectory is upwards, you can gain without someone else losing. Of course a market cannot have infinite growth so eventually it will stagnate or come down, but as long as it doesn't drop to zero, there is a net-profit outcome. But a futures market always has a net-zero outcome.

With futures markets it is more important than ever to ask yourself why you think you'll be the one gaining and not the one losing. with spot markets, it is possible for more people to gain than to lose, and may be considered less risky if this is the case (long-term investments often match this critera).

In futures markets, funding fees appear to be an example of how gains and losses are redistributed to ensure a zero-sum outcome.


Interesting follow up question: Can futures markets exist that are not zero-sum?

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Any part of you question about futures is above my pay grade since I know diddly about them. What I do know is that ignoring frictional costs, options and futures are a zero sum game. Winners win and losers lose, eg. a transfer of wealth.

Your mentioned stocks in your question and in a comment you defined a leveraged pool as pools that people put their money into that is loaned out to traders that use leverage so I'll try to address that.

If I buy 100 shares of XYZ for \$10k then there's a seller on the other side selling 100 shares of XYZ for \$10k. If I decide to go on full 50% margin, I can buy 200 shares of XYZ for \$20k and there has to be one or more sellers selling a total of 200 shares of XYZ to me for \$20k. It doesn't matter if this was just my own money or if I pooled money elsewhere (a hedge fund?). Winners win and losers lose. Transfer of wealth. The system isn't drained.

You stated:

...if the general trajectory of a price is upwards then there are more people making profit than making losses.

However, if more people are making profit than making losses, doesn't money have to be taken from the pools to be paid out to gainers, which results in the available money in the pools shrinking?`

The effect of leverage is that those who use it make or lose money faster. If those in your leveraged pool lose money, the leveraged pool shrinks. Those on the other side of the trade make money whether they are leveraged pools or retail investors. It's all just transfer of wealth.

Your question is complex and this answer may be way off so take it with a grain of salt if I misunderstood it.

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  • $\begingroup$ Thanks for your answer. If you are at 100x leverage, then to sell that, you need to find someone (or multiple people) to buy 100x your investment, which is relatively difficult, but still perfectly possible. However aren't future markets in closed systems, where practically everyone is using leverage? Doesn't it cause problems if the buyers are also at leverage? Doesn't it have to eventually trickle down to buyers that don't use leverage so that profits of one person are not coming from debt of another? $\endgroup$ Feb 16 at 18:45
  • $\begingroup$ I guess I could be wrong since people can't lose more than they put in. Anyway if you don't know much about futures (which I don't either) don't worry about trying to answer my question. $\endgroup$ Feb 16 at 18:46
  • $\begingroup$ In my stock example I used Reg T margin limit of 50%. The initial margin requirements varies for futures but at one of my brokers it's 2 to 12% of the notional value of the contract. Suppose it's 2% (50x leverage) and you buy one contract and I sell it. Assuming we're at the same broker, our margin requirements are identical. It makes no difference if I have 5% of the notional value of cash in my account or 20% of it. Whatever I make, you lose and vice versa. Remember zero sum? $\endgroup$ Feb 16 at 19:12
  • $\begingroup$ It's a leveraged security but it's still equivalent risk per contract. It wouldn't matter if I did 1 contract or 10 contracts. There's still an equal number of counterparty contracts on the other side of the trade. $\endgroup$ Feb 16 at 19:12
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This question is long, as are the answers. I am not sure whether the answers completely cover the intent of the question. I want to give a brief answer to what I see as the core of the question.

Futures. The futures market is zero sum; everybody’s gains/losses net to zero. (Negative if we take into account trading fees.) Futures are used because they have economic leverage, and are useful for hedging as well as speculating.

“Cash market.” For securities - stocks and bonds, the trading in the underlying instrument is referred to as the “cash market” - as opposed to derivatives markets (e.g., futures) where generally no cash is put down to enter the position. (You might pay option premia up front.) Intra-day trading in the cash market is zero sum, but over time, trading is positive sum since the underlying instruments have cash flows, and investors have to have a net position that is 100% long. Rising prices will generate capital gains. (If we measure performance versus benchmarks which capture the overall returns, trading can be viewed as zero sum - investors on average get the average return.)

Leveraged pools? What this is is unclear to me, but the description seems to be a group of investors that offer loans. The use of leverage does not affect the overall distribution of gains, it just allows some investors to take larger positions than they would have been able to if they could not borrow. If we are looking at “cash markets,” investors are still 100% long in aggregate. E.g., I could buy 50 or 100 shares from a seller with 100 shares depending on whether I use leverage. In either case, in total we still have 100 shares - if I buy 50, the seller is left with 50.

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