If you have seen “A Beautiful Mind”, where Russell Crowe plays the brilliant Dr. John Nash, you know about Game Theory.
Game Theory was a concept that was further developed by Nash, through which he created the now famous “Nash Equilibrium”.
The Nash Equilibrium, in turn, is a state in which, to put it simply, if all players in a game knew what the strategy of each other player in the game was going to do, but was unwilling to change his/her strategy, the equilibrium is reached.
Perhaps that was not so simple. Don’t worry, that doesn’t matter. What does matter is that game theory, if understood in a basic away, can greatly benefit your chances of “gaming” the stock market.
How does Game Theory help me?
Imagine you are in a strategic game with a dozen other members. Your goal, to put it simply, is to beat the other members.
If all the other members apply the same exact strategy to the situation, what should you do? Should you apply the same strategy as them, or should you do something different?
Let’s think about the two scenarios
Scenario A: You apply the same strategy. Therefore, all 13 members are applying the same exact strategy. The end result? Nobody wins, nobody loses. If it was a chess game, think of it as a draw, except with 13 members involved.
Scenario B: You apply a different strategy. In this case, the other 12 members will either all beat you, or you have the opportunity to beat them all.
Which scenario gets you the only chance to win? The answer, of course, is B.
Applying the concept to trading
If you think game theory doesn’t apply to trading, think again. Trading is all about game theory.
When you buy a stock, you are competing against other buyers.
And so the question comes down to who gets the better price. The answer to that question comes down to the strategy employed by each trader. In short, the trader who is making the more informed decision is the one who makes the better trade.
This, naturally, will lead to the obvious question: how do I know if I’m making the more informed decision?
The bad news is that it is impossible to answer that question with any sort of certainty.
The good news is that by understanding the nature of the markets- that is, the markets are nothing more than a strategic war among traders and investors who are all aiming for the same outcome- a profitable trade- it is possible to game the system to your advantage.
This article is not going to tell you how that is done, because if there is a “secret” towards winning the stock markets, everybody would employ it and, just like the original scenario with 13 members all fighting to win the strategic war, nobody would win.
Instead, think about this analogy. Why do you think that, when you watch Comedy Nights with Kapil or any other comedy/sitcom show, there is a live audience that laughs at the jokes? Similarly, why is it that certain Youtube videos that you normally would not watch end up generating millions of views? The answer to both of the above is the same: a sentiment is artificially created to prompt a response from you. Whether it is to get a laugh from you, or to get you to watch a video, the sentiment got triggered within your system.
And you acted.
But what if you did not act? What if you knew that without the live audience laughing, you probably would not laugh as much? What if you knew that without a marketing firm artificially getting a Youtube video to go viral, you would not have clicked the “like” button on Youtube? Would you have changed your decision?
Take a minute, and think about that. And then think about how it can apply to the stock markest.
And when it dawns upon you that when news comes out about a stock, or when the RBI makes an announcement, or news about crude oil comes from the Middle East and the market react immediately…
How are YOU going to react?
Food for thought 😉