Ed Thorp’s Remarkable Journey: From Beating Casinos to Dominating Wall Street

Ed Thorp, often hailed as the father of quantitative investing, is a name synonymous with unparalleled success in both the world of casinos and financial markets. His journey is a fascinating tale of turning what seemed unpredictable into a realm of predictability, long before the era of Wall Street’s quantitative wizards. In this exploration, we’ll delve into the remarkable life and trading strategies of Ed Thorp, with a focus on the key principles that guided his path to greatness.

Cracking the Casino Code

Ed Thorp’s genius first shone in the world of gambling. He achieved the seemingly impossible by deciphering the codes of casino games. In roulette, he designed a wearable computer that bestowed upon him an astonishing 44% edge. His innovation didn’t stop there; he also pioneered the world of blackjack by developing the very first card counting system, a technique still widely employed today.

Transitioning to Hedge Funds

Thorp’s prowess in gambling seamlessly transferred to the financial markets. His inaugural hedge fund, Princeton Newport Partners, boasted an astonishing track record, compounding money at an astounding rate of 19.1% for nearly two decades. This performance left the S&P 500 in the dust.

His second fund, managed from 1992 to 2002, continued the winning streak with an annualized return of 18.2%. Thorp’s influence extended far and wide, from discovering options pricing formulas before the Black-Scholes model to pioneering quantitative hedge funds.

The 1987 Crash: A Day of Calm Amidst Market Chaos

Black Monday stands etched in history as a day of sheer panic for most traders. But for Ed Thorp, it was an entirely different story. As the crash sent shockwaves through the financial world, Thorp was in the midst of his daily lunch date with his wife, Vivian.

Amidst the chaos, Thorp remained composed and unruffled. When the office urgently called to report the unfolding market turmoil, he didn’t betray even a hint of anxiety. Thorp’s calm demeanor was a testament to his meticulous preparation. He had painstakingly considered and accounted for all potential market scenarios, even the most catastrophic ones like the Black Monday crash.

Rather than succumbing to panic, Thorp calmly finished his lunch with Vivian and then retreated to the sanctuary of his thoughts. There, in the tranquility of his home, he embarked on a mission to exploit the situation that had engulfed the financial world.

After thinking hard about it overnight I concluded that massive feedback selling by the portfolio insurers was the likely cause of Monday’s price collapse. The next morning S&P futures were trading at 185 to 190 and the corresponding price to buy the S&P itself was 220. This price difference of 30 to 35 was previously unheard of, since arbitrageurs like us generally kept the two prices within a point or two of each other. But the institutions had sold massive amounts of futures, and the index itself didn’t fall nearly as far because the terrified arbitrageurs wouldn’t exploit the spread. Normally when futures were trading far enough below the index itself, the arbitrageurs sold short a basket of stocks that closely tracked the index and bought an offsetting position in the cheaper index futures. When the price of the futures and that of the basket of underlying stocks converged, as they do later when the futures contracts settle, the arbitrageur closes out the hedge and captures the original spread as a profit. But on Tuesday, October 20, 1987, many stocks were difficult or impossible to sell short. That was because of the uptick rule.

It specified that, with certain exceptions, short-sale transactions are allowed only at a price higher than the last previous different price (an “uptick”). This rule was supposed to prevent short sellers from deliberately driving down the price of a stock. Seeing an enormous profit potential from capturing the unprecedented spread between the futures and the index, I wanted to sell stocks short and buy index futures to capture the excess spread. The index was selling at 15 percent, or 30 points, over the futures. The potential profit in an arbitrage was 15 percent in a few days. But with prices collapsing, upticks were scarce.

What to do? I figured out a solution. I called our head trader, who as a minor general partner was highly compensated from his share of our fees, and gave him this order: Buy $5 million worth of index futures at whatever the current market price happened to be (about 190), and place orders to sell short at the market, with the index then trading at about 220, not $5 million worth of assorted stocks—which was the optimal amount to best hedge the futures—but $10 million. I chose twice as much stock as I wanted, guessing only about half would actually be shorted because of the scarcity of the required upticks, thus giving me the proper hedge. If substantially more or less stock was sold short, the hedge would not be as good but the 15 percent profit cushion gave us a wide band of protection against loss.

In the end we did get roughly half our shorts off for a near-optimal hedge. We had about $9 million worth of futures long and $10 million worth of stock short, locking in $1 million profit. If my trader hadn’t wasted so much of the market day refusing to act, we could have done several more rounds and reaped additional millions.

Spotting Unique Opportunities

Thorp’s knack for identifying unique opportunities extended beyond traditional markets. He invested in oil tankers when they were selling for scrap value, reaping substantial returns as demand for tankers fluctuated.

Along with Jerry Baesel, the finance professor from UCI who joined me at PNP, I spent an afternoon with Bruce in the 1980s in his Manhattan apartment discussing how he thought and how he got his edge in the markets. Kovner was and is a generalist, who sees connections before others do.

About this time he realized large oil tankers were in such oversupply that the older ones were selling for little more than scrap value. Kovner formed a partnership to buy one. I was one of the limited partners. Here was an interesting option. We were largely protected against loss because we could always sell the tanker for scrap, recovering most of our investment; but we had a substantial upside: Historically, the demand for tankers had fluctuated widely and so had their price. Within a few years, our refurbished 475,000-ton monster, the Empress Des Mers, was profitably plying the world’s sea-lanes stuffed with oil.

I liked to think of my part ownership as a twenty-foot section just forward of the bridge. Later the partnership negotiated to purchase what was then the largest ship ever built, the 650,000-ton Seawise Giant. Unfortunately for the sellers, while we were in escrow their ship unwisely ventured near Kharg Island in the Persian Gulf, where it was bombed by Iraqi aircraft, caught fire, and sank.

The Empress Des Mers operated profitably into the twenty-first century, when the saga finally ended. Having generated a return on investment of 30 percent annualized, she was sold for scrap in 2004, fetching almost $23 million, far more than her purchase price of $6 million.

Capitalizing on the SPAC Opportunity

In the aftermath of the 2008 financial crisis, Thorp capitalized on a unique opportunity presented by SPACs (special purpose acquisition corporations). Often dismissed by many, these closed-end funds offered a chance to purchase assets at a discount.

An unusual opportunity to buy assets at a discount arose during the financial crash of 2008–09, in the form of certain closed-end funds called SPACs. These “special purpose acquisition corporations” were marketed during the preceding boom in private equity investing. Escrowing the proceeds from the initial public offering (IPO) of the SPAC, the managers promised to invest in a specified type of start-up company.

SPACs had a dismal record by the time of the crash, their investments in actual companies losing, on average, 78 percent. When formed, a typical SPAC agreed to invest the money within two years, with investors having the choice—prior to the SPAC buying into companies—of getting back their money plus interest instead of participating.

By December 2008, panic had driven even those SPACs that still owned only US Treasuries to a discount to NAV. These SPACs had from two years to just a few remaining months either to invest or to liquidate and, before investing, offer investors a chance to cash out at NAV. In some cases we could even buy SPACs holding US Treasuries at annualized rates of return to us of 10 to 12 percent, cashing out in a few months. This was at a time when short-term rates on US Treasuries had fallen to approximately zero!

Navigating Runaway Inflation

Ed Thorp’s “runaway inflation trade” was a shrewd strategy he employed during a period of soaring inflation and remarkably high interest rates in 1981. Here’s a breakdown of how this trade worked:

1. Inflation and High Interest Rates: In 1981, the United States was grappling with runaway inflation. Short-term U.S. Treasury bills were yielding nearly 15 percent, and fixed-rate home mortgages had skyrocketed to over 18 percent per year. These extraordinary interest rates were a response to the rapidly rising prices in the economy.
2. Gold Futures Market Opportunity: Thorp identified an opportunity within the gold futures market, which was influenced by the prevailing economic conditions. Gold is often seen as a hedge against inflation and tends to rise in value when inflation is rampant.
3. Price Discrepancy: Thorp observed a significant price discrepancy in the gold futures market. Specifically, he noticed that gold futures contracts for delivery two months in the future were trading at a price of $400 per ounce, while contracts for delivery fourteen months out were trading at $500 per ounce. This price gap presented a lucrative opportunity.
4. The Trade: Thorp’s trade strategy was straightforward. He decided to buy gold at the lower price of $400 per ounce for delivery two months in the future. This meant that he committed to purchasing gold at this price with the expectation of taking possession of it in two months.
5. Profit Potential: Once Thorp acquired the gold at $400 per ounce, he held onto it for a nominal cost over the course of a year. After that year, he could deliver the gold, which had appreciated in value, for $500 per ounce. This meant he would gain a 25 percent profit in just twelve months.

The key to this trade was capitalizing on the price disparity between the short-term and long-term gold futures contracts, which was driven by the market’s anticipation of future inflation. By purchasing gold at a lower price and benefiting from its price appreciation over time, Thorp was able to leverage the extraordinary economic conditions to generate substantial returns.

This trade exemplifies Thorp’s ability to spot opportunities in the financial markets by closely analyzing market dynamics and economic factors, ultimately turning them into profitable ventures.

Market Efficiency According to Thorp

Thorp challenged the prevailing Efficient Market Hypothesis, asserting that market efficiency depends on the observer’s knowledge. With the right expertise, markets become predictable, and apparent randomness gives way to discernible patterns.

The Power of Combining Technicals and Fundamentals

In the mid-2000s, Thorp developed a trend-following futures strategy that underscored the efficacy of blending fundamental information with technical signals. This fusion enhanced trading outcomes, providing a competitive edge.

Beware of Anchoring

Thorp cautioned traders against anchoring themselves to entry prices. He emphasized the importance of detaching emotions from specific price levels, urging traders to remain adaptable and avoid becoming emotionally attached to past prices.

Interpreting Financial Headlines

Thorp advised traders to approach financial headlines with a critical eye. News narratives often magnify market moves, making it essential to distinguish between significant developments and market noise.

The Significance of Correlation

One of Thorp’s key insights was the significance of correlation in portfolio management. Diversifying positions with low correlations enhances risk management and improves the risk-reward profile.

The Complex World of Leverage

While acknowledging the potential benefits of leverage, Thorp stressed the importance of using it judiciously. Traders should assess their ability to withstand worst-case scenarios and reduce borrowing if necessary.

Unveiling the Kelly Criterion: A Money Management Formula

One of the cornerstones of Thorp’s trading success was his adept use of the Kelly Criterion, a money management formula designed to optimize position sizing. Here’s a detailed breakdown of how it works:

The Kelly Criterion is a mathematical formula that helps traders determine the optimal fraction of their capital to invest in a single trade. It is calculated as:

k% = (bp–q)/b, with p and q equaling the probabilities of winning and losing, respectively.

Where:

• k% is the fraction of capital to be invested.
• b is the net odds received on the trade (the ratio of profit to loss).
• p is the probability of winning the trade.
• q is the probability of losing the trade (1 – pp).

Let’s illustrate this with an example:

Suppose a trader has identified a trade with a 60% chance of winning (p=0.60) and a 40% chance of losing (q=0.40). The trade offers a 1:1 reward-to-risk ratio (b=1)).

Using the Kelly Criterion formula:

k%=((1⋅0.60)−0.40))/1 =0.20

In this example, the optimal fraction of capital to invest in the trade is 20%. This means that the trader should allocate 20% of their capital to this particular trade.

Risk Management During Drawdowns

During drawdowns, Thorp recommended a gradual reduction of positions to protect capital. Position sizes should be scaled down as losses accumulate, with the goal of preserving capital for future opportunities.

Ed Thorp’s journey from a casino innovator to a trading legend is a testament to his exceptional intelligence and adaptability. His unique insights and trading strategies continue to inspire and guide traders today, reminding us that success in the financial world requires a combination of innovation, discipline, and a keen understanding of the ever-evolving markets.

Gaining an Edge in Trading: The Path to Success

In the world of trading, the concept of having an “edge” is paramount. It’s the differentiating factor that separates successful traders from the rest. Ed Thorp, in his book “A Man For All Markets,” provides valuable insights into the sources of market inefficiency and how to exploit them.

Uncovering Market Inefficiency

Thorp’s journey through the intricacies of investing revealed a market rife with inefficiencies waiting to be harnessed. He identified several key aspects of market inefficiency:

1. Information Asymmetry: In the ever-evolving landscape of trading, information is power. Thorp noted that some individuals are privy to instant information while others lag behind. Information often begins with a select few and gradually disseminates, creating opportunities for those who act swiftly.
2. Limited Financial Rationality: Thorp recognized that in real markets, participants exhibit varying degrees of financial rationality. Some are highly rational, while others succumb to irrational behavior. This diversity in rationality opens doors for astute traders.
3. Incomplete Information: Traders often possess only partial information when determining a security’s fair price. The availability of relevant information varies, as does the time and ability to process and analyze it comprehensively.
4. Reaction to Information: The response to market-moving information varies. Sometimes, a flood of buy or sell orders within seconds leads to price gaps. In other cases, reactions are spread over minutes, hours, days, or even months, as documented in academic literature.

Exploiting Market Inefficiencies

Thorp’s insights extend to strategies for effectively exploiting these inefficiencies:

1. Early Access to Information: Timeliness is key. Obtaining good information early can be a game-changer. The ability to discern the quality and timeliness of information is a critical skill.
2. Disciplined Rationality: Embrace disciplined rationality in trading. Base decisions on logic and thorough analysis, avoiding the pitfalls of impulsive actions driven by sales pitches or emotions. An edge is only present when a rational affirmative case can withstand scrutiny.
3. Superior Analysis: Seek out superior methods of analysis. Thorp himself found success in various strategies, including statistical arbitrage, convertible hedging, the Black-Scholes formula, and even card counting in blackjack. Identifying a method that works for you is essential.
4. Timing is Crucial: Recognize that mispricings in securities draw the attention of traders. Early entrants tend to reap the greatest rewards, as their actions often correct the mispricing. Identifying opportunities and investing ahead of the crowd can yield substantial benefits.

In essence, Ed Thorp’s wisdom underscores the importance of cultivating a competitive edge in trading. It’s not merely about entering the market; it’s about entering with a well-defined advantage, making informed decisions, and having the discipline to seize opportunities when they arise. As Warren Buffett aptly puts it, “Only swing at the fat pitches.”