January 19th, 2021

To Beat the Market, You Must Have an Edge

Fortune's Formula Pt. 3: The Biggest Arbitrage Opportunity in Trading

This is the 3rd post in our 4-part series on Edward Thorp, a man who changed the games of blackjack and investing. Looking to catch up on the series? Check out the the previous posts here:

While math tricks and devices did favors for the game of blackjack, they also worked wonders in the stock market.

In the late 1950s, Shannon began an intensive study of the stock market that was motivated by both intellectual curiosity and desire for gain. He filled three library shelves with something like a hundred books on economics and investing. The titles included Adam Smith's The Wealth of Nations, John von Neumann and Oskar Morgenstern's Theory of Games and Economic Behavior, and Paul Samuelson's Economics, as well as books with a more practical focus on investment. One book Shannon singled out as a favorite was Fred Schwed's iconic classic, Where Are the Customers' Yachts, a book about greed on Wall Street.

“A trader who wants to beat the market must have an edge, a more accurate view of what bets on stocks are really worth.” – William Poundstone, Fortune's Formula

While designing the roulette computer with Thorp, Shannon kept a notebook devoted to the roulette device and part to a wildly disconnected set of stock market musings. He wondered about the statistical structure of the market's random walk and whether information theory could provide useful insights.

He told one of his Ph.D. students that the way to make money in the market was through arbitrage. Shannon saw the Kelly Criterion as the mathematical essence of arbitrage. However, that term was in the process of being redefined by the information age.

For example, if you spot a valuable record at a garage sale, buy it for a buck, and sell it for $200 to a collector, you’re participating in a form of arbitrage.

The term originally referred to a scheme for profiting from small price differences between geographically remote markets. Gilded Age financier Jay Gould discovered that the price of gold varied slightly between London and New York. Gould bought gold wherever it was cheaper and shipped it to wherever it was more expensive, selling it for a quick profit.

Arbitrage is a rather charged word. Those of leftish political convictions often see arbitrage as money for nothing, the epitome of Wall Street greed and fortunes made while providing little or no visible social benefit. To efficient market theorists, arbitrage is perhaps no less an affront. By definition, arbitrage opportunities cannot exist in an efficient market.

Instantaneous electronic communication has mostly erased geographic price disparities. Today arbitrage is used to describe almost any attempt to profit from irrationality in the market. Much like Gould, today's arbitrageurs usually buy and sell nearly the same thing at nearly the same time in order to make a profit. Because arbitrage profits can be quick, the return on investment may be far greater than with more conventional stock or bond investing.

Along with Shannon’s realization, Thorp has also pioneered many strategies which are now routinely used on Wall Street and throughout the hedge fund industry. Some of these strategies include:

  • Option Arbitrage
  • Warrant Modeling
  • Convertible Arbitrage
  • Index Arbitrage
  • Statistical Arbitrage

The biggest arbitrage opportunity lies in trading software. If you have powerful enough software, you can use it to detect minute variations in securities’ prices and capitalize on them. However, it’s going to cost you.

Automatic, trade-alert, and remote-alert software programs can set you back thousands of dollars. Furthermore, they’re not as powerful as the commercial-grade software used by big hedge funds and investment banks.

At the end of the day, technology continues to advance at a rapid rate which will likely make it harder for arbitrage or similar strategies. What may have worked in the past for Claude and Ed, may not work the same way moving forward.

The best thing to do is to account for the past, observe the present markets, and adapt and evolve using today’s technologies. Be sure to stay tuned for the 4th and final post in our series where we'll uncover how Thorp put his market strategies to the test and went from beating the dealer to beating the markets. Arbitrage
TagsArbitrageTrading Trading SoftwareWilliam PoundstoneClaude ShannonblackjackGamblingedward thorp