Beat the Market: A Scientific Stock Market System

"Ed Thorp is a really fascinating guy. He started as a physics graduate student before switching to maths at UCLA, where he developed an interest in gambling and in particular roulette. He thought that basic physics was pretty good at telling you how balls behave on rotating wheels and tried to use it to predict where the balls were going to land. That sounds a bit outlandish, but he believed that you could build a computer to do this and sure enough he did ultimately manage to do that. His interest in roulette took him to Las Vegas, where he also became interested in Blackjack. He realised that there was a source of information that was not being taken into account in the standard Blackjack strategy books, namely card counting. If you pay attention to the cards that have already appeared, he concluded, you can develop a strategy that allows you to reliably beat casinos at Blackjack. He wrote a book called Beat the Dealer, and in some ways Beat the Market is its sequel. After writing about Blackjack, Thorp began looking for other betting scenarios in which the methods he had developed to beat casinos could be used. Financial markets were natural candidates. So, he read as much as he could about statistics and stock markets – including Mandelbrot, Osborne Samuelson and Bachelier – and developed a version of Bachelier’s option pricing formula that he thought would give reliable predictions about the value of an option. Beat the Market really does draw on many of the ideas in his Blackjack book. One of the keys in Beat the Dealer is figuring out how to manage your money. In Blackjack you have to sit there playing at the table, watching how the cards come out; you know when conditions are bad for you and you know when the conditions are good. The question is how much you should bet under those different circumstances, because even if the conditions are good for you there’s a chance you could lose, so you don’t want to bet everything. At the same time, you also want to maximise your profits when things are in your favour. So, he developed a set of tools for thinking about how much to bet under certain circumstances. These tools also play a central role in his stock market strategy. “In 2007/2008 we continued using models that were designed for market conditions that disappeared in 2005.” What’s shocking about this book is how little attention it got when it was first published. Subsequently it has become something all quantitative hedge fund managers have read and Thorp has become something of an idol. These days people are so secretive about their trading strategies and the models they develop. In 1967, Thorp wrote book on how to do it, and almost no-one did anything with it. There was, however, a New York broker dealer called Jay Regan who recognised its importance and suggested to Thorp that they start a hedge fund together, which they did. They consistently made almost 20% a year over a 20-year period which is pretty outstanding. The methods they started with had been in the public domain through Thorp’s book, but no one else recognised their value."