Game Theory in Trading

Most noobs are taught to trade what they think or see which by default puts you on the same side as the herd. If 95% are losing, what are the chances that a new approach using a variation of the same old defunct concepts using the same old indicators is going to put you on the winning side of the curve?

Making a living in the markets requires that you identify and react to the behaviour of others, not analyzing patterns and using indicators to time trades.

The market makes sure that nobody has a static edge by repeating the same exact strategy. Otherwise, it would get massively exploited with huge capital. If there was such a loophole that developed, it would be quickly closed. If participants instantaneously catch onto it then the price returns to complete efficiency. This action is not created by any individual or specific group, it is the auction itself and all the participants acting in the entirety that create the movement.

The bars, indicators, patterns, systems, structure, and action are all driven by what the other party is doing. The other party is the cause and everything else is the effect.

This is why some of the best "setups" you see still often fail to produce winning trades. We use tools and visuals to have context in what we decide to do relevant to direction and timing but the outcome after the entry is made is driven by the other party.

There are no "winning" entries. There are no winning trades that are decided in advance as many would like to believe. It is a game of who has the will to hang in there and who will push the other out. It is a game of poker and a game of chicken. I best compare it to a tennis match in which one player will wear the other down to the point that an unforced error is made.

Many of us are correct in direction and premise on our winning trades but still end up donating to the market. This is the a result of the trader on the other side having the ability to wear us down and force an error.

The market cannot be defeated with a static set of rules because it is dynamic. The players have to constently change up the action in order to keep the price fair. Those that play poker will agree that you can not win repeatedly at poker by making the same bets on the same types of hands. Same goes for trading. Either you are going to get pushed out or your opponent is. Successful trading is about engagement with the other traders. You get a random hand each time. Whoever plays the hand the best wins. The player with the best hand is not always going to be the winner.

Judging by all the systems/methods and discussions on FF, very few traders think about the person on the other side of their trade (ok we know its the broker but their prices come from the interbank of competing traders). This is the single most important factor in trading imo and will often decide the outcome of your success. Next time you stick an indicator on your chart, think about what you are doing and why.

Great post porkpie and I have to say, thanks to some of the guys here on the forum my eyes have really opened. There is a whole other world here outside the indicators and PA which explains everything more detailed but it requires more effort, I might not be there yet but I'll sure as hell get there at some point.

Anyway what I wanted to mention was that it does not only apply only to indicators.
When I started FF everyone was so anti-indicators so I said to myself that all these people can't be wrong. So I started reading into PA and J16.
And what I want to say is that it doesn't just apply to indicators, it applies to PA aswell. Think about why the pin is a pin, and why you should take it. Think about why 95% of traders lose (FA and TA traders). Maybe you'll come to a conclusion that there is another analysis.. who knows?

Great post porkpie.
Thank you.

So this is a roundabout justification for order flow trading?

Cause and effect is a natural action, instead of the be-all you imply. Those in control of how the price moves are an effect as well as the cause, since they act in stereotypical ways that technical charting can break from random into tradeable.

Don't get me wrong, lots including me would like a nice, easy approach to order flow for trading. It's that, at the least, one would have to have viewed it up close for a while and then somehow related it to us plebes' level.

It would be good for a trader to look at game theory, as it immediately has us thinking about the other participants, their actions and their goals, rather than watching some silly squiggly line.

I do not agree with the following statement though:

I believe this is incorrect, and that the strategy of participants is fairly static. If the behaviour of the herd does not change, there is nothing to drive change for any other participant. Do you really think the herd is any sharper than they were 100 years ago? I really, really doubt it.
I could imagine an academic making such an argument, and by doing so showing complete ignorance of the participants of the game. Who is going to close that loophole? The skilled participants are already exploiting it, and the rest don't know better, and never will.

The nature of a market has nothing to do with keeping price fair; instead it serves to transfer wealth from the unskilled to the skilled. Skilled participants position themselves to profit, not to search for a fair price.

Not true at all. It may be the case if you're playing live against the same table of regulars, but it is quite different online, which is far more comparable to trading. Online, at low-medium limits (which support more professionals than upper limits), quite a few participants will catch on to playstyle, but few will negate it, and even fewer will be able to exploit it. Any decent player is able to switch gears anyway, and therefore exploit their image at the table. This isn't changing method, strategy or system, it's part of the strategy.

Of those that catch on, the only group to worry about are competing professionals. They will recognise your play quite quickly, and you theirs, and generally you will be quite cautious of each other. Why? Because it is generally better to focus on the weaker participants. This is the natural outcome between predators in an ecosystem abundant in prey. So, a change in the predator will usually require a shake up of the ecosystem - something to make it significiantly more competitive than it was before. This would require a new participant at the top of the food chain, one group of predators to outcompete the others, or a significant number of prey elevating their status. Even still, edges are so large in trading that the change would have to be extraordinary to render current methods obsolete - methods that at their core are hundreds, even thousands of years old, only counting their use in human history.

I don't think this is correct either, as this is one part of trading that doesn't correlate well to poker. In trading, we can jump in and out of the table's action at will. In fact, it's as if none of us know our hands at all, and we're playing an enternal game of trying to bet each other out of the pot.

Also, it is not true that the hand best played wins. The aim is to maxmimise ev, not to win. A good player at a full table will fold many hands, and each and every hand play better than the others. A more specific example is a moron who pushes postflop every hand. We get a pair of kings, and we call. He may turn over a pair of aces, and we probably lose, but that does not mean we played the hand poorly, or that our opponent played it better.

Don't take this as me being overly critical of your post - overall I think it's quite valuable to unskilled traders, as it gets them thinking about playing the opponent rather than their hand - the first step. My disagreements above philosophical, and may not have a significant effect on how trades are placed. This may make the post seem petty, but I think a strong philophy is essential to trading. There is more value in its debate than in comparing indicators or systems.

where all the noobs???4


interesting,if we taught the noobs the trader physchology ,and the physchology of the marketplace
then everyone would win,and marketmakers would loose
if marketmakers loose,retail trading is dead
or they would have to hedge our bets,raise spread,and make faster hedge execution algorithms

but if u dont help traders,then they will loose,maketmakers will win,more of the same,lesser spread
and more monies for better traders

at the end it doesnt even matter,u help traders,they win,higher spread,for us,
where is all this going,?
why should we trade forex,when its a big mess,
just trade futures its centralised and u can see evryones trades,not always they can iceberg their trades in the marketdepth,still volume is there,there isnt 1000s of marketmakers giving different quotes

who wins who losses,competent and incompetent
its the survival of the fittest in this trading jungle

we are in a waging war,against each other,we can help our fellow friends,but not evryone ,if we help evryone whos the looser gonna be,how long can it last?
will a new system be made so the bureacracy can make money as long as it wants

?????
what is the point of this thread,to help whom?
is it a discussion for the traders that already get it?
or a discussion for the noobs to learn new stuff
this can go on the on
how far will we go into the organised chaos ???

will this thread change noobs thinking,the noob gets smarter
marketmakers loose money
they have to change their trading
more unexpected for us
more stophunting in areas not expected

or will it be just better,if we get the fuk out of forex,and trade futures,with real people and all types of players,in a centralised arena,

my choice is the futures
im out of here,its a good thing,not many traders havent got the mind of us,how else will the minority winners make their money

if you raise the level of all, the smart will rise above, the lazy will go under

if you lower the level of all, the smart will get lazy and go down with them all

I thought the more ppl who use the same technique is better?

more ppl buy pushes price up no?

So that kinda contradicts the technique you say that you have to go against the flow?


I thought , being with the flow is better, maybe with the flow of winners? most are the flow of losers.

you are correct when you say why certain trade setup fails, but thats just probability in this random market such as like in poker, theres always random variations, donkey calls badbeating you etc.

If you ask the exact reason, there will be no answer because forex is so huge with so many participant, what made the setup fails really is unknown. And if you try to long while everyone is short, going against the flow. isnt that bad because the price is going to go down as demand is less?


so overall, aint poker and forex just a game of gambling, only way to win is to beat yourself in money management? does anyone really want to trade for their whole life ? even jesse livermore has suffered big loss and huge set backs, hes not god. But he did +EV at the end but ended his life after a huge loss anyway. can the game really be won?

Why did jesse livermore said his life was a failure?

are we all chasing stars?

To have an edge, you'd have to be thinking a bit more tactical. Consider this quote:

"All warfare is based on deception. Hence, when able to attack, we must seem unable; when using our forces, we must seem inactive; when we are near, we must make the enemy believe we are far away; when far away, we must make him believe we are near."
... Sun Tzu

It's all about competing to get in and out of the market. If everyone used the same method and they are buying who are they buying from? Think more in terms of seeking out areas of liquidity and positioning yourself for attack. Where are liquidity pools likely to be? What happens when everyone has been buying and there are no more buyers? What possibilities does that open to the sellers especially to a stack of sellers waiting in ambush.

MrJ great post. Not critical at all just the response I wanted to get me thinking more on the issue and will address later.

Dragan, trading is a zero sum game and the extreme minority who outperform the others will always take all the money regardless of tactics.

Many traders executing a similar game theory strategy as the pros cannot have an effect on the reliability of a given strategy. There are 2 reasons why:

The first being that in order for this to happen, the market would have to be a fixed, mechanical apparatus that repeats the same standard deviations from a start point exactly the same. The market is a living and breathing auction. If too many people enter at the same area, that area is no longer wholesale and traders will be pushed or squeezed out.

Most retail traders are unwilling or unable to get proper training. There will always be a constant flow of new traders to join those who refuse to get help that have no idea what they are doing. This will always be able to be exploited by the few who truly understand this game.

I agree with Mr J that there is definitely a static edge in the market, which is a function of human behavior which never changes. What changes is only the market dynamics, and individual strategies need some adjustments from time to time. I think what needs to be pointed out is that there are two edges that are required. One is the static edge that is caused by the herd mentality which creates inefficiencies in the market, and it’s not based on the “Game Theory”.

The second edge is a statistical approach to exploiting the first edge. I believe that understanding the concepts and dynamics of both is what allows professionals to take money from amateurs on consistent basis.

The main edge that professionals have, is the stream of greedy unskilled participants coming into the market who put money into the pot so the professionals can exploit them. Even many hedge funds belong to this category. The amateurs cannot handle trading environment because the skills they bring into trading are in direct conflict of what works for them in the society. On top of that we as human beings are wired to associate pain with losing and we want to avoid pain at all costs. Even our school system is part of a huge “Employment Agency ”where we’re programmed to be “right” otherwise we’re ridiculed and even ostracized, and then when we become traders subsequently we want very high W/L ratios which would give us comfort of being “right”. Professionals are no longer susceptible to such weaknesses and this is their edge.

What Porkpie was referring to has to do more less with being able to think in probabilities, which again amateurs find very difficult to do, yet for pros this is second nature. The Game Theory is way too complex and not realistic in financial modeling. I’d suggest that the best proof of a static edge in the market that is being exploited by professionals, is understanding how human beings (amateurs in the context of this thread) are very irrational and inefficient decision makers. This in my opinion has more to do with Behaviour Finance and Prospect Theory, rather than with Game Theory.

The Prospect Theory has won a Nobel Prize in economics, and proves how humans have tendency to do the opposite of what it takes to winning in the markets. This is a static edge that never changes. It was even present in the markets when Jesse Livermore was trading. Once people understand the concepts behind it, and immerse themselves into psychological work to address their psychological biases and weaknesses, then all they have to do is to overlay this edge with secondary edge that is actually based on technical analysis and statistics. I could be wrong, but I think that focusing just on the statistical edge through technical analysis is only half part of the solution to greater success.

I believe that consistently working on own psychology and improving ourselves rather than our system is where lots of the edge comes from. Then what really matters is the long term distribution of outcomes and integrating it with proper money management, and then creating a business plan, and so on.

Nice theory.

Turning into practice is the hardest part.

Congrats on this really good thread. Can't agree more with all the points you've made.

Excellent thread and discussion Exactly the kind of thinking one needs to go through before betting a single penny.

Please allow me to, in the interest of mutual learning and development, question some statements made.

The first part of this statement is simply not true. Some simple and static strategies have remained profitable over many years.

The second part of the statement depends on your liquidity requirements. For example lets consider (a) a multi-$B hedge fund wanting to make another few $B, (b) a $300M hedge fund with investor expectations of 30% return, and (c) a retail or small prop trader taking positions no larger than 5M of base currency.

For market participant (a), the analogy of game theory certainly applies. It's first a game of information, maybe by buying informants in all relevant organisations and paying to influence the information flow through media and news services, as well as informal networks. Second, it's a game of using that information flow and truly understanding supply and demand when using the large funds available to build positions while moving the market in the right direction.

For market participant (b), privy to what is going on among participants of type (a), it's a matter of scaling in and out of a position while following the trend created by the behaviour of (a).

This all leaves participants of type (c) with a juicy loophole that is too small for the larger participants to even consider.

While the fx market, in a sense, is a zero-sum game, this analogy has limited applicability because all participants aren't players. In the early days, it was simply a case of clearing banks feeding off corporates and central banks. Consider the example of a US importer, a Japanese exporter, and the clearing banks handling their fx transactions. Both importer and exporter may be highly satisfied with their banking services while the banks are reaping handsome profits. In other words, some participants are happily providing the funds that become the profits of other participants.

In reality it is of course more complex than that, but I think the analogy of an eco-system may be more apt than that of a poker game. Take a look at the picture below. The clown fish is covered in mucus for the protection against the tentacles of the anemones in which they hide. The small fish are feeding off the mucus while at the same time protecting the anemones.

I don't think it's helpful or correct to view the market as an adversary in a poker game. Psychologically it breeds fear in the trader, and structurally it isn't true, at least for the retail trader. The market doesn't give a hoot about what the small guy does.

As an illustration, consider the clown fish. Does it mind the small fish eating the mucus? Not at all as long as they don't eat all of it so that the clown fish gets hurt by the anemones.

Similarly, in the fx market, as long as you don't eat too much liquidity nobody cares about what you do. Only when you clip volumes that get noticed at the dealing banks would you be in danger. As an example, say a dealing desk notices that somebody out of LCG, probably a retail account, is taking away much desired liquidity in large clips around the market open - then you may be in danger of being taught a lesson with the market as adversary, but not until then.

Using the eco-system analogy, the task for the trader becomes one of finding one's niche to feed in. Then the market is a friend, not an adversary, and one can be happy and safe in a relatively static place even while swimming with sharks.

So it becomes a question of understanding the eco-system of the market, and one's place in it. We need to learn as much as possible about the other fish, how they move and feed, and then identify our niche and how to exploit it.

In this context, the first part of the following statement fits like hand in glove, but I wonder about the second part.

Once you've gained a satisfactory understanding of the eco-system of the market, is there anything left other than patterns and indicators to base decisions on?

And can you really identify "others" and their behaviour by any other means?

From what I've researched so far, there are really certain mass behavioral patterns which haven't changed yet over the course of the last few years/decades. I think as long as humans or algorithms created by humans trade the markets, we can trade on these mass behavioral inefficiencies.
Just finding those is not that easy sometimes.

One of the best lines written on here. It is the absolute truth.

Nice analogy to an excellent thread

Dynamic within a set of static rules. Try applying static rules to multiple timeframes.

If the monthly does x, wait for the weekly to do x, then the daily, h4 and h1, right down to m1 if you like a really tight entry.

Trends within trends are incredibly reliable.

Nice posts Mr J and Medici, thanks.

Hello Old Friend, long time no see, and thanks for kind words I'm happy that you are joining this interesting discussion.