Imagine Hunter Biden and his friend are caught stealing money.
Not much of a stretch…
The FBI pulls them into separate rooms and demands they confess.
They can choose to rat out the other person or remain silent.
The penalties vary based on the actions of each person.
- If both of them confess, both get eight years in prison.
- If both remain silent, they both get one year in prison.
- If one confesses while the other remains silent, the one who confesses goes free while the one who kept silent gets 10 years.
We can draw the scenarios out like this:
Hunter and his friend must decide what to do. Yet, each person doesn’t know what the other person will do.
This is what’s known as the Prisoner’s Dilemma, a classic game theory application.
It teaches us to think through economic decisions and is invaluable to investing.
Today, we’re going to help you understand this next-level thinking and offer simple techniques to improve your investing performance by grounding it in the study of game theory.
What is Game Theory
Chess is all about game theory.
Each player makes moves based on the current layout and what each person thinks the other person will do.
The best decision for one player, known as a “strategy”, often depends on what strategies the other players choose.
There are different outcomes (or “payoffs”) for each combination of strategies, and the goal is to find the strategy that gives the best payoff.
Let’s go back to the Prisoner’s Dilemma to help illustrate this point.
We need to figure out what the dominant strategy is for each person.
The best way to do that is to walk through the decisions each person would make based on the two scenarios:
- If Hunter believes his friend will confess, then his best option is to confess.
- This gives him eight years in prison.
- If he doesn’t confess and he thinks his friend will, then he gets 10 years in prison.
- If Hunter believes his friend will remain silent, then his best option is to confess.
- This gives him zero years in prison.
- If he doesn’t confess and he thinks his friend won’t confess, then he gets one year in prison.
Confessing becomes the dominant strategy for both players since they don’t know what the other person will do, and this yields the best possible outcomes.
However, if the game is played repeatedly, and the results are known after each game, we now get the potential for collusion.
The key to understanding game theory boils down to:
- The information available.
- The number of times you can play the “game.”
As Applied to Markets
Raise your hand if you ever bought a stock that was already up a great deal because you didn’t want to miss out.
The only way this makes sense is if you believe someone else would buy the stock at a higher price from you.
In fact, that’s the only reason any of us buy a stock (ignoring dividends, etc.) — we believe someone else will buy it for more than what we paid.
But how do you know someone might be willing to pay more for the stock?
Are you betting on the “bigger fool” theory — that someone else will get suckered into buying a stock because they think there’s another sucker down the line?
Or do you believe you have information that tells you there’s more value here than someone else sees and once they do, they’d be willing to pay more for that stock?
This is what’s referred to as “next-level” thinking.
You’re making a decision based on what you think others will do in the future.
Let’s use the Russell rebalancing as an example.
This known event occurs once a year when the Russell Index changes its components based on a published formula.
Since we know when this is going to happen, we could buy stocks that are going to be added to the index in anticipation of the rebalance.
But let’s take that to the next-level thinking stage.
Someone else knows that we’re anticipating the rebalancing. So, he or she buys those stocks ahead of us to profit from our decisions.
In theory, this can keep going on and on and on.
However, we really only need to go one or two levels deep. Anything more is unnecessary.
The Important Questions
We now come to the heart of the matter — making better investment decisions.
Let’s cover the obvious:
- You don’t have any news information that someone else doesn’t already have.
- There are bigger players with a lot more money to perform better research.
- Technology and volume have eliminated a lot of those “arbitrage” opportunities in trading.
Sounds kind of bleak. But here are some things you probably didn’t think about:
- Big money players can’t take positions all at once without moving price and screwing themselves over.
- You can choose when to buy or sell stocks and options, meaning you can pick the most advantageous times.
- No matter how much information is out there, people can and do make irrational decisions all the time based on emotions.
Your flexibility as a retail investor gives you an edge that big money cannot match.
For example, you can choose to sell options when premiums are high, knowing that, based on history, there is a high probability those premiums will shrink.
Essentially, you could sell an option for $5.00 and buy it back for $4.00 within a day when a stock goes nowhere, profiting entirely off volatility contraction.
Even simpler, you can buy stocks, like Coca-Cola (KO), after their recent selloff at low valuations if you believe:
- People were forced to sell because the stock dropped.
- You have a longer investing horizon than the people who unloaded the stock.
- The people who sold the stock were irrational.
That’s why every time you make any investment or trade you want to ask the following questions:
- What do I think other people will do now and in the future?
- Why will those people make those decisions?
- Could those decisions change?
Going back to the Coca-Cola example, do you think that people will keep selling the stock here? If they will, why would they do that?
In our minds, someone willing to unload the stock of a slow-moving company after it’s dropped some +20% must have a pretty dour view of the economy… or… they jumped on the bandwagon.
Well, could they have a worse view of the economy than everyone else?
Chances are, they’re stodgy investors who get too riled up about inflation and want to protect their assets.
Down the road, they’ll probably realize they’re wrong and end up buying back in at higher prices.
Do we know that for sure?
Of course not.
But that’s the thought process we want you to take away today.
Now, we mentioned that retail investors have a clear advantage when selling options.
Options prices increase when demand (i.e., volatility is high) and decrease when it’s low.
Think of it like a sound wave.
You want to sell at the top and buy at the bottom.
We can’t know ahead of time when volatility might rise.
But we CAN identify when it’s high.
And that’s exactly how Bryan Perry puts together some of his most lucrative options trades in his Eight-Month Millionaire Blueprint.
Bryan breaks down the process into digestible bits, making it possible for even the newest traders to exploit this edge.
He walks you through every trade, explaining not just what he’s doing, but why.
You’ll get a chance to see how a veteran trader applies game theory thinking in real-life trading.